Text of JCT Tax Simplification Report Available -- Volume I (Part 1 of 3)

[Editor's Note: For online presentation purposes, the text of this JCT print has been broken up into three parts; text of the remainder of JCS-3-01 appears under the next two citations.]

[1] The Joint Committee staff recommends that out of date and obsolete provisions in the Code should be eliminated. The Joint Committee staff has identified more than 100 provisions that could be eliminated as deadwood.

JOINT COMMITTEE ON TAXATION

107TH CONGRESS, 1ST SESSION

HOUSE SENATE

The Joint Committee on Taxation study of the overall state of the Federal tax system and recommendations to simplify taxpayer and administrative burdens is required by the IRS Restructuring and Reform Act of 1998 and funded by appropriations approved by the Congress.

The study was prepared and produced by virtually the entire Joint Committee staff. Special recognition must be given to Mary Schmitt and Carolyn Smith who helped on every stage of this project, from planning and coordinating staff teams to the final editing of the report. In addition, Rick Grafmeyer, who left the staff last year, was instrumental in assisting in the planning of this report. Cecily Rock, who contributed to various portions of the report, also coordinated the final production of the Joint Committee staff recommendations in Volume II.

This study was prepared by the legislative staff of the Joint Committee on Taxation, each of whom contributed to this final product: Carolyn D. Abraham, Secretary; R. Gregory Bailey, Legislation Counsel; Thomas A. Barthold, Senior Economist; E. Ray Beeman, Legislation Counsel; B. Jean Best, Secretary; John H. Bloyer, Chief Clerk; Michael E. Boren, Administrative Assistant; Mary Ann Borrelli, Economist; Tanya Butler, Statistical Analyst; Roger Colinvaux, Legislation Counsel; William J. Dahl, Senior Computer Specialist; John W. Diamond, Economist; Timothy A. Dowd, Economist; Patrick A. Driessen, Senior Economist; Christopher P. Giosa, Economist; H. Benjamin Hartley, Senior Legislation Counsel; Robert P. Harvey, Economist; Patricia A. Hensley, Data Set Specialist; Harold E. Hirsch, Senior Legislation Counsel; Thomas P. Holtmann, Economist; Melani Houser, Chief Statistical Analyst; Deirdre A. James, Legislation Counsel; Ronald A. Jeremias, Senior Economist; Gary Koenig, Economist; Thomas F. Koerner, Associate Deputy Chief of Staff; Lauralee A. Matthews, Senior Legislation Counsel; Patricia M. McDermott, Legislation Counsel; Debra L. McMullen, Senior Staff Assistant; Neval E. McMullen, Staff Assistant; Brian A. Meighan, Accountant; Pamela H. Moomau, Senior Economist; Tracy S. Nadel, Director Of Tax Resources; John F. Navratil, Economist; Joseph W. Nega, Legislation Counsel; Hal G. Norman, Computer Specialist; Melissa A. O'Brien, Tax Resource Specialist; Samuel Olchyk, Legislation Counsel; Christopher J. Overend, Economist; Lindy L. Paull, Chief of Staff; Oren S. Penn, Legislation Counsel; Cecily W. Rock, Senior Legislation Counsel; Lucia J. Rogers, Secretary; Bernard A. Schmitt, Deputy Chief of Staff; Mary M. Schmitt, Deputy Chief of Staff; Todd C. Simmens, Legislation Counsel; Christine J. Simmons, Secretary; Carolyn E. Smith, Associate Deputy Chief of Staff; William T. Sutton, Senior Economist; Melvin C. Thomas, Jr., Senior Legislation Counsel; Michael A. Udell, Economist; and Barry L. Wold, Legislation Counsel. In addition, the following former staff members contributed to this report: David P. Hering, Paul M. Schmidt, and Melbert E. Schwarz.

The Joint Committee staff gratefully acknowledges the contribution of the academic and tax policy advisors for the significant commitment of time and substantive contributions they made to the development of this report. The tax policy advisors provided guidance on the principal focus of the report, and the academic advisors provided significant input on the recommendations in the report. The meetings with the advisors were a rare opportunity for our staff to engage in informative and thought-provoking discussions with former government officials and scholars. The advisors are listed in Appendices A and B, respectively, of Volume I. Special recognition is given to three of the advisors who spent significant time working as consultants to the Joint Committee staff: Patricia E. Dilley, Christopher H. Hanna, and Frances R. Hill, and to the advisors who prepared papers for inclusion in Volume III of this study: Jonathan Barry Forman, Deborah A. Geier, Frances R. Hill, Annette Nellen, George K. Yin, and David J. Shakow.

The Joint Committee staff also recognizes the significant contributions of the General Accounting Office and the Congressional Research Service to this study. The work of these organizations is reproduced in Appendices C and D, respectively, of Volume I.

Lindy L. Paull

[2] This document,/1/ is a report of the staff of the Joint Committee on Taxation ("Joint Committee staff") in connection with a study of the overall state of the Federal tax system. This report is being transmitted, as required under section 8022(3)(B) of the Internal Revenue Code of 1986, to the House Committee on Ways and Means and the Senate Committee on Finance. Under section 8022(3)(B), the Joint Committee staff is required to report at least once each Congress on the overall state of the Federal tax system and to make recommendations with respect to possible simplification proposals and other matters relating to the administration of the Federal tax system. ²

[3] The Joint Committee staff is publishing this study in three volumes. Volume I of this study contains Part One (Executive Summary and Joint Committee on Taxation Staff Study Mandate and Methodology), Part Two (Overall State of the Federal Tax System), and four Appendices (Academic Advisors to the Joint Committee on Taxation, Tax Policy Advisors to the Joint Committee on Taxation, General Accounting Office Materials, and Congressional Research Service Materials). Volume II of this study contains Part Three (Recommendations of the Joint Committee on Taxation Staff to Simplify the Federal Tax System). Volume III of this study contains papers relating to simplification submitted to the Joint Committee on Taxation by tax scholars in connection with the study.

² Section 8022(3)(B) was added by section 4002(a) of the Internal Revenue Service Restructuring and Reform Act of 1998.

I. EXECUTIVE SUMMARY

A. STUDY MANDATE AND METHODOLOGY

[4] Under the Internal Revenue Code, the Joint Committee on Taxation ("Joint Committee") is required to report, at least once each Congress, to the Senate Committee on Finance and the House Committee on Ways and Means on the overall state of the Federal tax system. ¹ This study is required to include recommendations with respect to possible simplification proposals and such other matters relating to the administration of the Federal tax system as the Joint Committee may deem advisable.

[5] In the course of this study, the Joint Committee staff:

(1) undertook an extensive review of prior simplification

B. BACKGROUND INFORMATION ON THE FEDERAL TAX SYSTEM

[7] The Joint Committee staff collected background information on the sources of complexity in the Federal tax law and data concerning the filing of tax forms, taxpayer assistance, and information on error rates and tax controversies. Some of the information collected by the Joint Committee staff (with the assistance of the General Accounting Office) included the following:

(1) Over 100 million individual income tax returns are filed

[8] In the course of its study, the Joint Committee staff identified various sources of complexity in the present-law Federal tax system. No single source of complexity can be identified that is primarily responsible for the state of the present-law system. Rather, the Joint Committee staff found that, for any complex provision, a number of different sources of complexity might be identified.

[9] Among these sources of complexity the Joint Committee staff identified are: (1) a lack of clarity and readability of the law; (2) the use of the Federal tax system to advance social and economic policies; (3) increased complexity in the economy; and (4) the interaction of Federal tax laws with State laws, other Federal laws and standards (such as Federal securities laws, Federal labor laws and generally accepted accounting principles), the laws of foreign countries, and tax treaties. The lack of clarity and readability of the law results from (1) statutory language that is, in some cases, overly technical and, in other cases, overly vague; (2) too much or too little guidance with respect to certain issues; (3) the use of temporary provisions; (4) frequent changes in the law; (5) broad grants of regulatory authority; (6) judicial interpretation of statutory and regulatory language; and (7) the effects of the Congressional budget process.

D. EFFECTS OF COMPLEXITY ON THE FEDERAL TAX SYSTEM

[10] There are a number of ways in which complexity can affect the Federal tax system. Among the more commonly recognized effects are (1) decreased levels of voluntary compliance; (2) increased costs for taxpayers; (3) reduced perceptions of fairness in the Federal tax system; and (4) increased difficulties in the administration of tax laws. Although there is general agreement among experts that complexity has these adverse effects, there is no consensus on the most appropriate method of measuring the effects of complexity. The Joint Committee staff explored certain information that may be helpful in assessing the possible effects of complexity in the present-law Federal tax system.

[11] It is widely reported that complexity leads to reduced levels of voluntary compliance. Complexity can create taxpayer confusion, which may affect the levels of voluntary compliance through inadvertent errors or intentional behavior by taxpayers. The Joint Committee staff found that it is not possible to measure the effects of complexity on voluntary compliance because (1) there has been no consistent measurement of the levels of voluntary compliance in more than a decade and (2) there is no generally agreed measure of changes in the level of complexity in the tax system over time.

[12] Commentators also state that complexity of the Federal tax systems results in increased costs of compliance to taxpayers. The Joint Committee staff explored some of the commonly used measures of the costs of compliance, such as the estimate of time required to prepare tax returns, but found that there is no reliable measure of the change in costs of compliance. The Joint Committee staff did find, however, that individual taxpayers have significantly increased their use of tax return preparers, computer software for tax return preparation, and IRS taxpayer assistance over the last 10 years.

[13] Complexity reduces taxpayers' perceptions of fairness of the Federal tax system by (1) creating disparate treatment of similarly situated taxpayers, (2) creating opportunities for manipulation of the tax laws by taxpayers who are willing and able to obtain professional advice, and (3) disillusioning taxpayers to Federal tax policy because of the uncertainty created by complex laws.

[14] Finally, complexity makes it more difficult for the IRS to administer present law. Complex tax laws make it more difficult for the IRS to explain the law to taxpayers in a concise and understandable manner in forms, instructions, publications, and other guidance. In addition, the IRS is more likely to make mistakes in the assistance provided to taxpayers and in the application of the law.

E. IDENTIFYING PROVISIONS ADDING COMPLEXITY

[15] In conducting this study, the Joint Committee staff looked at a variety of factors that contribute to complexity. Although the Joint Committee staff's focus was on complexity as it affects taxpayers (either directly or through the application of the law by tax practitioners), the Joint Committee staff also took into account complexity encountered by the IRS in administering the tax laws.

[16] The Joint Committee staff generally did not take into account the level of sophistication of taxpayers or the complexity of transactions in identifying complex provisions; however, as discussed below, such factors were taken into account in making recommendations for simplification.

[17] Factors the Joint Committee staff analyzed in identifying provisions that add complexity include the following:

(1) the existence of multiple provisions with similar

1. Overview

[18] The Joint Committee staff analyzed each possible simplification recommendation from a variety of perspectives, including:

(1) the extent to which simplification could be achieved by

[20] Among the types of issues with respect to which the Joint Committee staff did not make specific simplification recommendations because of policy considerations are the following: (1) reducing the number of individual income tax filing statuses; (2) determining marital status; (3) reducing the number of exclusions from income; (4) making structural modifications to above-the-line deductions and itemized deductions; (5) increasing the standard deduction; (6) making structural changes to the dependency exemption, the child credit, and the earned income credit; (7) modifying the treatment of home mortgage interest of individuals; (8) modifying the distinction between ordinary income (and losses) and capital gains (and losses); (9) integrating the corporate and individual income tax; (10) altering the basic rules relating to corporate mergers and acquisitions; (11) eliminating the personal holding company and accumulated earnings tax provisions; (12) reducing the number of separate tax rules for different types of pass-through entities; (13) determining whether an expenditure is a capital expenditure that cannot be currently expensed; (14) modifying the rules relating to depreciation of capital assets; (15) providing uniform treatment of economically similar financial instruments; (16) modifying the rules relating to taxation of foreign investments; (17) modifications to the foreign tax credit; (18) altering the taxation of individual taxpayers with respect to cross border portfolio investments overseas; (19) changing the determination of an individual's status as an employee or independent contractor; (20) clarifying the treatment of limited partners for self-employment tax purposes; (21) providing alternative methods of return filing; and (22) eliminating overlapping jurisdiction of litigation relating to the Federal tax system.

[21] The Joint Committee staff did not conclude that a simplification recommendation was inconsistent with the underlying policy of a provision merely because the recommendation might alter the taxpayers affected.

[22] In some instances, the Joint Committee staff concluded that a provision did not accomplish the underlying policy articulated when the provision was enacted. In such instances, the Joint Committee staff concluded that recommending elimination or substantial modification of a provision was not inconsistent with the underlying policy.

2. Alternative minimum tax

[23] The Joint Committee staff recommends that the individual and corporate alternative minimum taxes should be eliminated. The individual and corporate alternative minimum taxes contribute complexity to the present-law tax system by requiring taxpayers to calculate Federal income tax liability under two different systems.

[24] The Joint Committee staff believes that the individual alternative minimum tax no longer serves the purposes for which it was intended. The present-law structure of the individual alternative minimum tax expands the scope of the provisions to taxpayers who were not intended to be alternative minimum tax taxpayers. The number of individual taxpayers required to comply with the complexity of the individual alternative minimum tax calculations will continue to grow due to the lack of indexing of the minimum tax exemption amounts and the effect of the individual alternative minimum tax on taxpayers claiming nonrefundable personal credits. By 2011, the Joint Committee staff projects that more than 11 percent of all individual taxpayers will be subject to the individual alternative minimum tax.

[25] Furthermore, legislative changes since the Tax Reform Act of 1986 have had the effect of partially conforming the tax base for alternative minimum tax purposes to the tax base for regular tax purposes. Thus, the Joint Committee staff finds it appropriate to recommend repeal of the alternative minimum tax.

3. Individual income tax

Uniform definition of a qualifying child

[26] The Joint Committee staff recommends that a uniform definition of qualifying child should be adopted for purposes of determining eligibility for the dependency exemption, the earned income credit, the child credit, the dependent care tax credit, and head of household filing status. Under this uniform definition, in general, a child would be a qualifying child of a taxpayer if the child has the same principal place of abode as the taxpayer for more than one half the taxable year. Generally, a "child" would be defined as an individual who is (1) the son, 10 daughter, stepson, stepdaughter, brother, sister, stepbrother, or stepsister of the taxpayer or a descendant of any of such individuals, and (2) under age 19 (or under age 24 in the case of a student). As under present law, the child would have to be under age 13 for purposes of the dependent care credit. No age limit would apply in the case of disabled children. Adopted children, children placed with the taxpayer for adoption by an authorized agency, and foster children placed by an authorized agency would be treated as the taxpayer's child. A tie-breaking rule would apply if more than one taxpayer claims a child as a qualifying child. Under the tie-breaking rule, the child generally would be treated as a qualifying child of the child's parent.

[27] Adopting a uniform definition of qualifying child would make it easier for taxpayers to determine whether they qualify for the various tax benefits for children and reduce inadvertent taxpayer errors arising from confusion due to different definitions of qualifying child. A residency test is recommended as the basis for the uniform definition because it is easier to apply than a support test.

[28] This recommendation would provide simplification for substantial numbers of taxpayers. Under present law, it is estimated that, for 2001, 44 million returns will claim a dependency exemption for a child, 19 million returns will claim the earned income credit, 6 million returns will claim the dependent care credit, 26 million returns will claim the child credit, and 18 million returns will claim head of household filing status.

Dependent care benefits

[29] The Joint Committee staff recommends that the dependent care credit and the exclusion for employer-provided dependent care assistance should be conformed by: (1) providing that the amount of expenses taken into account for purposes of the dependent care credit is the same flat dollar amount that applies for purposes of the exclusion (i.e., $5,000 regardless of the number of qualifying individuals); (2) eliminating the reduction in the credit for taxpayers with adjusted gross income above certain levels; and (3) providing that married taxpayers filing separate returns are eligible for one half the otherwise applicable maximum credit.

[30] The recommendation would eliminate the confusion caused by different rules for the two present-law tax benefits allowable for dependent care expenses. The recommendation also would simplify the dependent care credit by eliminating features of the credit that require additional calculations by taxpayers.

[31] This recommendation could provide simplification for as many as 6 million returns, the number of returns estimated to claim the dependent care credit in 2001.

Earned income credit

[32] The Joint Committee staff recommends that the earned income credit should be modified as follows: (1) the uniform definition of qualifying child (including the tie-breaking rule) recommended by the Joint Committee staff should be adopted for purposes of the earned income credit; and (2) earned income should be defined to include wages, salaries, tips, and other employee compensation to the extent includible in gross income for the taxable year, and net earnings from self employment.

[33] Applying the uniform definition of child recommended by the Joint Committee staff to the earned income credit would make it easier for taxpayers to determine whether they qualify for the earned income credit and would reduce inadvertent errors caused by different definitions. The elimination of nontaxable compensation from the definition of earned income would alleviate confusion as to what constitutes earned income and enable taxpayers to determine earned income from information already included on the tax return.

[34] This recommendation could provide simplification for as many as 19 million returns, the number of returns estimated to claim the credit in 2001.

Head of household filing status

[35] The Joint Committee staff recommends that head of household filing status should be available with respect to a child only if the child qualifies as a dependent of the taxpayer under the Joint Committee staff's recommended uniform definition of qualifying child. Applying the uniform definition of child recommended by the Joint Committee staff would make it easier for taxpayers to determine if they are eligible for head of household status due to a child and reduce taxpayer errors due to differing definitions of qualifying child.

[36] This recommendation could provide simplification for up to 18 million returns that are estimated to be filed in 2001 using head of household filing status.

Surviving spouse status

[37] The Joint Committee staff recommends that surviving spouse status should be available only for one year and that the requirement that the surviving spouse have a dependent should be eliminated. The recommendation would eliminate confusion about who qualifies for surviving spouse status.

Phase-outs and phase-ins

[38] The Joint Committee staff recommends that the following phase-outs should be eliminated: (1) overall limitation on itemized deductions (known as the "PEASE" limitation); (2) phase-out of personal exemptions (known as "PEP"); (3) phase-out of child credit; (4) partial phase-out of the dependent care credit; (5) phase-outs relating to individual retirement arrangements; (6) phase-out of the HOPE and Lifetime Learning credits; (7) phase-out of the deduction for student loan interest; (8) phase-out of the exclusion for interest on education savings bonds; and (9) phase-out of the adoption credit and exclusion.

[39] These phase-outs require taxpayers to make complicated calculations and make it difficult for taxpayers to plan whether they will be able to utilize the tax benefits subject to the phase-outs. Eliminating the phase-outs would eliminate complicated calculations and make planning easier. These phase-outs primarily address progressivity, which can be more simply addressed through the rate structure.

[40] This recommendation would provide simplification for up to 30 million returns that are subject to one or more of the present law phase-outs and phase-ins.

Taxation of Social Security benefits

[41] The Joint Committee staff recommends that the amount of Social Security benefits includible in gross income should be a fixed percentage of benefits for all taxpayers. The Joint Committee staff further recommends that the percentage of includible benefits should be defined such that the amount of benefits excludable from income approximates individuals' portion of Social Security taxes. The recommendation would eliminate the complex calculations and 18-line worksheet currently required in order to determine the correct amount of Social Security benefits includible in gross income. This recommendation could provide simplification for as many as 12 million returns that show taxable Social Security benefits; 5.7 million of such returns are in the income phase-out range.

Individual capital gains and losses

[42] The Joint Committee staff recommends that the current rate system for capital gains should be replaced with a deduction equal to a fixed percentage of the net capital gain. The deduction should be available to all individuals. The recommendation would simplify the computation of the taxpayer's tax on capital gains and streamline the capital gains tax forms and schedules for individuals for as many as 27 million returns estimated to have capital gains or losses in 2001.

[43] The Joint Committee staff recommends that, for purposes of ordinary loss treatment under sections 1242 and 1244, the definition of small business should be conformed to the definition of small business under section 1202, regardless of the date of issuance of the stock. The recommendation would reduce complexity by conforming the definition of small business that applies for purposes of preferential treatment of capital gain or loss.

Two-percent floor on miscellaneous itemized deductions

[44] The Joint Committee staff recommends that the two-percent floor applicable to miscellaneous itemized deductions should be eliminated. The Joint Committee staff finds that the two-percent floor applicable to miscellaneous itemized deductions has added to complexity because it has: (1) placed pressure on individuals to claim that they are independent contractors, rather than employees; (2) resulted in extensive litigation with respect to the proper treatment of certain items, such as attorneys' fees; (3) resulted in inconsistent treatment with respect to similar items of expense; and (4) created pressure to enact deductions that are not subject to the floor. Although the two-percent floor was enacted, in part, to reduce complexity, it has instead shifted complexity to these other issues relating to miscellaneous itemized deductions.

Provisions relating to education

Definition of qualifying higher education expenses

[45] The Joint Committee staff recommends that a uniform definition of qualifying higher education expenses should be adopted. A uniform definition would eliminate the need for taxpayers to understand multiple definitions if they use more than one education tax incentive and reduce inadvertent taxpayer errors resulting from confusion with respect to the different definitions.

Combination of HOPE and Lifetime Learning credits

[46] The Joint Committee staff recommends that the HOPE and Lifetime Learning credits should be combined into a single credit. The single credit would: (1) utilize the present-law credit rate of the Lifetime Learning credit; (2) apply on a per-student basis; and (3) apply to eligible students as defined under the Lifetime Learning credit.

[47] Combining the two credits would reduce complexity and confusion by eliminating the need to determine which credit provides the greatest benefit with respect to one individual and to determine if a taxpayer can qualify for both credits with respect to different individuals.

Interaction among education tax incentives

[48] The Joint Committee staff recommends that restrictions on the use of education tax incentives based on the use of other education tax incentives should be eliminated and replaced with a limitation that the same expenses could not qualify under more than one provision. The recommendation would eliminate the complicated planning required in order to obtain full benefit of the education tax incentives and reduce traps for the unwary. The recommendation would eliminate errors by taxpayers due to the provisions that trigger adverse consequences as a result of actions by persons other than the taxpayer.

Student loan interest deduction

[49] The Joint Committee staff recommends that the 60-month limit on deductibility of student loan interest should be eliminated. The recommendation would make determining the amount of deductible interest easier because taxpayers would not need to determine the history of the loan's payment status.

Exclusion for employer-provided educational assistance

[50] The Joint Committee staff recommends that the exclusion for employer-provided educational assistance should be made permanent. The recommendation would reduce administrative burdens on employers and employees caused by the present practice of allowing the exclusion to expire and then extending it. The recommendation would make it easier for employees to plan regarding education financing. The recommendation would eliminate the need to apply a facts and circumstances test to determine if education is deductible in the absence of the exclusion.

Taxation of minor children

[51] The Joint Committee staff recommends that the tax rate schedule applicable to trusts should be applied with respect to the net unearned income of a child taxable at the parents' rate under present law. In addition, the Joint Committee staff recommends that the parental election to include a child's income on the parents' return should be available irrespective of (1) the amount and type of the child's income, and (2) whether withholding occurred or estimated tax payments were made with respect to the child's income. Utilizing the trust rate schedule would eliminate the complexity arising from the linkage of the returns of parent, child, and siblings. Expanding the parental election would decrease the number of separate returns filed by children.

4. Individual retirement arrangements, qualified retirement plans, and employee benefits

Individual retirement arrangements ("IRAs")

[52] The Joint Committee staff recommends that the income limits on eligibility to make deductible IRA contributions, Roth IRA contributions, and conversions of traditional IRAs to Roth IRAs should be eliminated. Further, the Joint Committee staff recommends that the ability to make nondeductible contributions to traditional IRAs should be eliminated. The Joint Committee staff recommends that the age restrictions on eligibility to make IRA contributions should be the same for all IRAs.

[53] The IRA recommendations would reduce the number of IRA options and conform eligibility criteria for remaining IRAs, thus simplifying taxpayers' savings decisions.

Recommendations relating to qualified retirement plans

Definition of compensation

[54] The Joint Committee staff recommends that: (1) a single definition of compensation should be used for all qualified retirement plan purposes, including determining plan benefits, and (2) compensation should be defined as the total amount that the employer is required to show on a written statement to the employee, plus elective deferrals and contributions for the calendar year. The recommendation would eliminate the need to determine different amounts of compensation for various purposes or periods.

Nondiscrimination rules for qualified plans

[55] The Joint Committee staff recommends that: (1) the ratio percentage test under the minimum coverage rules should be modified to allow more plans to use the test, (2) excludable employees should be disregarded in applying the minimum coverage and general nondiscrimination rules, and (3) the extent to which cross-testing may be used should be specified in the Code. The first recommendation would simplify minimum coverage testing by eliminating the need for some plans to perform the complex calculations required under the average benefit percentage test. The second recommendation would simplify nondiscrimination testing by eliminating the need to analyze the effect of covering excludable employees under the plan. The third recommendation would provide certainty and stability in the design of qualified retirement plans that rely on cross-testing by eliminating questions as to whether and to what extent the cross-testing option is available.

Vesting requirements

[56] The Joint Committee staff recommends that the vesting requirements for all qualified retirement plans should be made uniform by applying the top-heavy vesting schedules to all plans. A single set of vesting rules would provide consistency among plans and will reduce complexity in plan documents and in the determination of vested benefits.

SIMPLE plans

[57] The Joint Committee staff recommends that the rules relating to SIMPLE IRAs and SIMPLE 401(k) plans should be conformed by (1) allowing State and local government employers to adopt SIMPLE 401(k) plans, (2) applying the same contribution rules to SIMPLE IRAs and SIMPLE 401(k) plans, and (3) applying the employee eligibility rules for SIMPLE IRAs to SIMPLE 401(k) plans. This recommendation would make choosing among qualified retirement plan designs easier for all small employers.

Definitions of highly compensated employee and owner

[58] The Joint Committee staff recommends that uniform definitions of highly compensated employee and owner should be used for all qualified retirement plan and employee benefit purposes. Uniform definitions would eliminate multiple definitions of highly compensated employee and owner for various purposes, thereby allowing employers to make a single determination of highly compensated employees and owners.

Contribution limits for tax-sheltered annuities

[59] The Joint Committee staff recommends that the contribution limits applicable to tax-sheltered annuities should be conformed to the contribution limits applicable to comparable qualified retirement plans. Conforming the limits would reduce the recordkeeping and computational burdens related to tax-sheltered annuities and eliminate confusing differences between tax-sheltered annuities and qualified retirement plans.

Minimum distribution rules

[60] The Joint Committee staff recommends that the minimum distribution rules should be simplified by providing that: (1) no distributions are required during the life of a participant; (2) if distributions commence during the participant's lifetime under an annuity form of distribution, the terms of the annuity will govern distributions after the participant's death; and (3) if distributions either do not commence during the participant's lifetime or commence during the participant's lifetime under a nonannuity form of distribution, the undistributed accrued benefit must be distributed to the participant's beneficiary or beneficiaries within five years of the participant's death. The elimination of minimum required distributions during the life of the participant and the establishment of a uniform rule for post-death distributions would significantly simplify compliance by plan participants and their beneficiaries, as well as plan sponsors and administrators.

Exceptions to the early withdrawal tax; half-year conventions

[61] The Joint Committee staff recommends that the exceptions to the early withdrawal tax should be uniform for all tax-favored retirement plans and that the applicable age requirements for the early withdrawal tax and permissible distributions from section 401(k) plans should be changed from age 59-1/2 to age 55. Uniform rules for distributions would make it easier for individuals to determine whether distributions are permitted and whether distributions will be subject to the early withdrawal tax.

Allow all governmental employers to maintain section 401(k) plans

[62] The Joint Committee staff recommends that all State and local governments should be permitted to maintain section 401(k) plans. This will eliminate distinctions between the types of plans that may be offered by different types of employers and simplify planning decisions.

Redraft provisions dealing with section 457 plans

[63] The Joint Committee staff recommends that the statutory provisions dealing with eligible deferred compensation plans should be redrafted so that separate provisions apply to plans maintained by State and local governments and to plans maintained by tax-exempt organizations. This will make it easier for employers to understand and comply with the requirements applicable to their plans.

Attribution rules

[64] The Joint Committee staff recommends that the attribution rules used in determining controlled group status under section 1563 should be used in determining ownership for all qualified retirement plan purposes. Uniform attribution rules would enable the employer to perform a single ownership analysis for all relevant qualified retirement plan purposes.

Basis recovery rules for qualified retirement plans and IRAs

[65] The Joint Committee staff recommends that a uniform basis recovery rule should apply to distributions from qualified retirement plans, traditional IRAs, and Roth IRAs. Under this uniform rule, distributions would be treated as attributable to basis first, until the entire amount of basis has been recovered. The uniform basis recovery rule would eliminate the need for individuals to calculate the portion of distributions attributable to basis and would apply the same basis recovery rule to all types of tax-favored retirement plans.

Modifications to employee benefit plan provisions

Cafeteria plan elections

[66] The Joint Committee staff recommends that the frequency with which employees may make, revoke, or change elections under cafeteria plans should be determined under rules similar to those applicable to elections under cash or deferred arrangements. Applying simpler election rules to cafeteria plans would reduce confusion and administrative burdens for employers and employees.

Excludable employees

[67] The Joint Committee staff recommends that a uniform definition of employees who may be excluded for purposes of the application of the nondiscrimination requirements relating to group- term life insurance, self-insured medical reimbursement plans, educational assistance programs, dependent care assistance programs, miscellaneous fringe benefits, and voluntary employees' beneficiary associations should be adopted. A uniform definition of excludable employees would eliminate minor distinctions that exist under present law and make nondiscrimination testing easier.

5. Corporate income tax

Collapsible corporations

[68] The Joint Committee staff recommends that the collapsible corporation provisions should be eliminated. This recommendation would eliminate a complex provision that became unnecessary with the enactment of the corporate liquidation rules of the Tax Reform Act of 1986.

Active business requirement of section 355

[69] The Joint Committee staff recommends that the active business requirement of section 355 should be applied on an affiliated group basis. Thus, the "substantially all" test should be eliminated. This recommendation would simplify business planning for corporate groups that use a holding company structure.

Uniform definition of a family

[70] The Joint Committee staff recommends that a uniform definition of a family should be used in applying the attribution rules used to determine stock ownership. For this purpose, a "family" should be defined as including brothers and sisters (other than step- brothers and step-sisters), a spouse (other than a spouse who is legally separated from the individual under a decree of divorce whether interlocutory or final, or a decree of separate maintenance), ancestors and lineal descendants. An exception would be provided with respect to limiting multiple tax benefits in the case of controlled corporations (section 1561), in which case the present-law rules of section 1563(e) would be retained. A single definition of a family would eliminate many of the inconsistencies in the law that have developed over time and would reflect currently used agreements relating to divorce and separation.

Redemption through use of related corporations (section 304)

[71] The Joint Committee staff recommends that section 304 should apply only if its application results in a dividend (other than a dividend giving rise to a dividends received deduction). The recommendation would limit the application of a complex set of rules.

Corporate reorganizations

[72] The Joint Committee staff recommends that assets acquired in a tax-free reorganization pursuant to section 368(a)(1)(D) or 368(a)(1)(F) should be allowed to be transferred to a controlled subsidiary without affecting the tax-free status of the reorganization. This recommendation would harmonize the rules regarding post-reorganization transfers to controlled subsidiaries and eliminate the present-law uncertainties with respect to such transfers.

[73] The Joint Committee staff recommends that the rules relating to the treatment of property received by a shareholder in reorganizations involving corporations under common control or a single corporation (or a section 355 transaction) should be conformed to the rules relating to the redemption of stock. This recommendation would simplify business planning by conforming the rules for determining dividend treatment if a continuing shareholder receives cash or other "boot" in exchange for a portion of the shareholder's stock.

Corporate redemptions

[74] The Joint Committee staff recommends that a stock redemption incident to a divorce should be treated as a taxable redemption of the stock of the transferor spouse, unless both parties agree in writing that the stock is to be treated as transferred to the other spouse prior to the redemption. If one spouse actually receives a distribution and purchases the other spouse's stock, the form of the transaction would be respected. The recommendation would eliminate uncertainty and litigation regarding the treatment of the parties when a corporate stock redemption occurs incident to a divorce.

6. Pass-through entities

Partnerships

[75] The Joint Committee staff recommends that references in the Code to "general partners" and "limited partners" should be modernized consistent with the purpose of the reference. In most cases, the reference to limited partners could be updated by substituting a reference to a person whose participation in the management or business activity of the entity is limited under applicable State law (or, in the case of general partners, not limited). In a few cases, the reference to limited partners could be retained because the provisions also refer to a person (other than a limited partner) who does not actively participate in the management of the enterprise, which can encompass limited liability company owners with interests similar to limited partnership interests. In one case, the reference to a general partner can be updated by referring to a person with income from the partnership from his or her own personal services. The recommendation would provide simplification by modernizing these references to accommodate limited liability companies, whose owners generally are partners within the meaning of Federal tax law, but are not either general partners or limited partners under State law.

[76] The Joint Committee staff recommends that the special reporting and audit rules for electing large partnerships should be eliminated and that large partnerships should be subject to the general rules applicable to partnerships. The recommendation would simplify the reporting and audit rules by eliminating the least-used sets of rules.

[77] The Joint Committee staff recommends that the timing rules for guaranteed payments to partners and for transactions between partnerships and partners not acting in their capacity as such should be conformed. The timing rule for all such payments and transactions should be based on the time the partnership takes the payment into account. The recommendation would provide simplification by eliminating one of two conflicting timing rules applicable to similar types of situations.

S corporations

[78] The Joint Committee staff recommends that the special termination rule for certain S corporations with excess passive investment income should be eliminated. In addition, the corporate- level tax on excess passive investment income should be modified so that the tax would be imposed only on an S corporation with accumulated earnings and profits in any year in which more than 60 percent (as opposed to 25 percent) of its gross income is considered passive investment income. The recommendation would eliminate much of the uncertainty and complexity of present law for S corporations that are required to characterize their income as active or passive income, and at the same time would conform the tax with the personal holding company rules applicable to C corporations (that address a similar concern).

[79] The Joint Committee staff recommends that the special rules for the taxation of electing small business trusts should be eliminated and that the regular rates of Subchapter J should apply to these trusts and their beneficiaries. Under this recommendation, no election to be a qualified subchapter S trust could be made in the future. The recommendation would eliminate some of the complexity regarding the operating rules for electing small business trusts as well as the overlapping rules for electing small business trusts and qualified Subchapter S trusts.

7. General business issues

Like-kind exchanges

[80] The Joint Committee staff recommends that a taxpayer should be permitted to elect to rollover gain from the disposition of appreciated business or investment property described in section 1031 if like-kind property is acquired by the taxpayer within 180 days before or after the date of the disposition (but not later than the due date of the taxpayer's income tax return). The determination of whether properties are considered to be of a "like-kind" would be the same as under present law.

[81] The Joint Committee staff recommends that, for purposes of determining whether property satisfies the holding period requirement for a like-kind exchange, a taxpayer's holding period and use of property should include the holding period and use of property by the transferor in the case of property (1) contributed to a corporation or partnership in a transaction described in section 351 or 721, (2) acquired by a corporation in connection with a transaction qualifying as a reorganization under section 368, (3) distributed by a partnership to a partner, and (4) distributed by a corporation in a transaction to which section 332 applies. In addition, the Joint Committee staff recommends that property whose use changes should not qualify for like-kind exchange treatment unless it is held for productive use in a trade or business or investment for a specified period of time.

[82] The recommendation would reduce complexity by allowing taxpayers to reinvest the proceeds from the sale of business or investment property into other like-kind property directly without engaging in complicated "exchanges" designed to meet the statutory and regulatory rules regarding deferred exchanges. In addition, the recommendation would remove the confusion and uncertainty under section 1031 with respect to whether a taxpayer is considered to hold property for productive use in a trade or business or for investment when the property has been recently transferred.

Low-income housing tax credit

[83] The Joint Committee staff recommends that the payout period for the low-income housing tax credit should be conformed to the initial compliance period (15 years). This recommendation would eliminate the present-law credit recapture rules, which are a significant source of complexity for the credit.

Rehabilitation tax credit

[84] The Joint Committee staff recommends that the 10-percent credit for rehabilitation expenditures with respect to buildings first placed in service before 1936 should be eliminated. Thus, the rehabilitation credit would not be a two-tier credit, but instead would provide only a 20-percent credit with respect to certified historic structures.

[85] The recommendation would achieve simplification in two respects. First, it would eliminate the overlapping categories of "old" and "historic" buildings eligible for different levels of credit under present law. Second, it would eliminate the record- keeping burden currently imposed under the 10-percent credit.

Orphan drug tax credit

[86] The Joint Committee staff recommends that the definition of qualifying expenses for the orphan drug tax credit should be expanded to include expenses related to human clinical testing incurred after the date on which the taxpayer files an application with the Food and Drug Administration for designation of the drug under section 526 of the Federal Food, Drug, and Cosmetic Act as a potential treatment for a rare disease or disorder. As under present law, the credit could only be claimed for such expenses related to drugs designated as a potential treatment for a rare disease or disorder by the Food and Drug Administration in accordance with section 526 of such Act. The recommendation would reduce complexity by treating all human clinical trial expenses in the same manner for purposes of the credit and any allowable deduction.

Work opportunity tax credit and welfare-to-work tax credit

[87] The Joint Committee staff recommends that the work opportunity tax credit and welfare-to-work tax credit should be combined and subject to a single set of rules. The combined credit would be simpler for employers because they would use a single set of requirements when hiring individuals from all the targeted groups of potential employees.

Indian employment credit

[88] The Joint Committee staff recommends that the Indian employment credit should be calculated without reference to amounts paid by the employer in 1993. Eliminating the incremental aspect of the credit would reduce the record retention burden on taxpayers in the event the credit is extended permanently.

Reduced emissions vehicles

[89] The Joint Committee staff recommends that the tax benefit for reduced emissions vehicles should be a deduction of qualified expenses related to all such qualifying vehicles, provided that the Congress chooses to extend the tax benefits applicable to such vehicles. Fewer tax benefit options for a similar policy goal would simplify taxpayer decision making and promote a uniform incentive.

8. Accounting provisions

Cash method of accounting

[90] The Joint Committee staff recommends that a taxpayer with less than $5 million of average annual gross receipts should be permitted to use the cash method of accounting and should not be required to use an accrual method of accounting for purchases and sales of merchandise under section 471. A taxpayer that elects not to account for inventory under section 471 would be required to treat inventory as a material or supply that is deductible only in the amount that it is actually consumed and used in operations during the tax year. The recommendation would not apply to tax shelters and would not alter the rules for family farm corporations. The recommendation would enlarge the class of businesses that can use the cash method of accounting, which is a simpler method of accounting. Such businesses would have reduced recordkeeping requirements and would not need to understand the requirements associated with an accrual method of accounting.

Organizational costs

[91] The Joint Committee staff recommends that the rules and requirements to elect to amortize organizational costs should be codified in a single Code provision irrespective of the choice of entity chosen by the taxpayer. In addition, organizational costs incurred in the formation of entities that are, or are elected to be, disregarded for Federal income tax purposes would be eligible to recover organization costs over 60 months. The recommendation would consolidate the rules governing the treatment of organizational costs for all types of entities into one provision and would clarify the tax treatment of organizational costs incurred with respect to legal entities that are disregarded for Federal income tax purposes.

Mid-quarter convention for depreciation

[92] The Joint Committee staff recommends that the mid-quarter convention for depreciable property should be eliminated. This calculation, which requires an analysis of property placed in service during the last three months of any taxable year, can be complex and burdensome because taxpayers must wait until after the end of the taxable year to determine the proper placed-in-service convention for calculating depreciation for its assets during the taxable year. The recommendation would simplify the rules for calculating depreciation, because an analysis of property would no longer need to be performed with respect to property placed in service during the last three months of a taxable year to determine application of the mid-quarter convention.

9. Financial products and institutions

Straddle rules

[93] The Joint Committee staff recommends that the general loss deferral rule of the straddle rules should be modified to allow the identification of offsetting positions that are components of a straddle at the time the taxpayer enters into a transaction that creates a straddle, including an unbalanced straddle. Straddle period losses would be allocated to the identified offsetting positions in proportion to the offsetting straddle period gains and would be capitalized into the basis of the offsetting position.

[94] The Joint Committee staff recommends that the exception for stock in the definition of personal property should be eliminated. Thus, offsetting positions involving actively traded stock generally would constitute a straddle.

[95] Modifying the general loss deferral rule to permit identification of offsetting positions in a straddle would eliminate an additional level of complexity and uncertainty encountered by taxpayers in applying the loss deferral rules to straddles, particularly unbalanced straddles. Similarly, eliminating the stock exception would simplify the straddle rules by eliminating an exception that has become very complex in practice and only applies to a narrow class of transactions.

Interest computation

[96] The Joint Committee staff recommends that the eight different regimes for imposing interest on deferred taxes should be consolidated into three separate regimes: (1) an annual interest charge rule; (2) a look-back rule in which estimates are used; and (3) a look-back rule in which the tax is allocated to prior years based on the applicable Federal rate. The interest rate that would be applied in connection with the three separate regimes would be a uniform rate. Consolidating the interest charge rules would reduce complexity by providing a more uniform application of rules that fulfill the same policy of imposing interest on the deferral of tax. Computing the interest charges at a uniform rate would further reduce the complexity of interest charges.

Taxation of annuities

[97] The Joint Committee staff recommends that section 72, relating to taxation of annuities, should be redrafted to eliminate overly convoluted language and improve the readability of the statutory language. The Joint Committee staff provides a recommended redraft of a portion of section 72 for public review and comment.

[98] In addition, the Joint Committee staff recommends that the provisions of section 72 that apply to qualified retirement plans should be separated from the other provisions of section 72 and combined with the other rules governing the taxation of distributions from such plans. The recommendations would provide simplification by improving the readability of the provisions and by grouping related provisions together so they can be more easily found and understood.

Insurance companies

[99] The Joint Committee staff recommends that the special rules permitting a deduction for certain reserves for mortgage guaranty insurance, lease guaranty insurance, and insurance of State and local obligations should be eliminated. The recommendation would reduce complexity by eliminating tax rules that principally serve a financial accounting purpose.

[100] The Joint Committee staff recommends that the special rules provided to Blue Cross and Blue Shield organizations in existence on August 16, 1986, should be eliminated. Appropriate rules would be provided for taking into account items arising from the resulting change in accounting method for tax purposes. Complexity would be reduced by eliminating special rules that are based on historical facts and that are of declining relevance to the tax treatment of health insurers.

[101] The Joint Committee staff recommends that the two five- year rules relating to consolidated returns of affiliated groups including life insurance companies and nonlife insurance companies should be eliminated. Appropriate conforming rules should be provided. The complexity both to the acquired corporations and the existing members of the affiliated group in corporate acquisitions involving life insurance and nonlife insurance companies would be reduced, with respect to recordkeeping and with respect to calculation of tax liability.

10. International provisions

Foreign personal holding companies, personal holding companies, and foreign investment companies

[102] The Joint Committee staff recommends that (1) the rules applicable to foreign personal holding companies and foreign investment companies should be eliminated, (2) foreign corporations should be excluded from the application of the personal holding company rules, and (3) subpart F foreign personal holding company income should include certain personal services contract income targeted under the present-law foreign personal holding company rules. The recommendation would provide relief from the complex multiple sets of overlapping anti-deferral regimes that potentially apply to U.S. owners of stock in a foreign corporation.

Subpart F de minimis rule

[103] The Joint Committee staff recommends that the subpart F de minimis rule should be modified to be the lesser of five percent of gross income or $5 million (increased from the present-law dollar threshold of $1 million). For taxpayers with relatively modest amounts of subpart F income, the recommendation would provide relief from the complexity and compliance burdens involved in separately accounting for income under the subpart F anti-deferral rules.

Look-through rule for 10/50 companies

[104] The Joint Committee staff recommends that, for foreign tax credit limitation purposes, the look-through approach should be immediately applied to all dividends paid by a 10/50 company (regardless of the year in which the earnings and profits were accumulated). The recommendation would provide relief from recordkeeping burdens on U.S. corporations required to account for dividends paid by a 10/50 company under both the single basket limitation approach and the look-through approach.

Deemed-paid foreign tax credits

[105] The Joint Committee staff recommends that a domestic corporation should be entitled to claim deemed-paid foreign tax credits with respect to a foreign corporation that is held indirectly through a foreign or U.S. partnership, provided that the domestic corporation owns (indirectly through the partnership) 10 percent or more of the foreign corporation's voting stock. The recommendation would clarify uncertainty in the law that may exist with respect to the application of the indirect foreign tax credit rules when a partner indirectly owns an interest in a foreign corporation through a partnership.

Section 30A and section 936

[106] The Joint Committee staff recommends that, if the credits under section 30A and section 936 are extended (these provisions will expire after 2005), consideration should be given to conforming the application of the credit across all possessions and to combining the rules in one Code section. The recommendation would improve the readability of the rules for potential credit claimants with operations in Puerto Rico and other U.S. possessions by consolidating similar requirements for claiming such credits in one Code section.

Uniform capitalization rules

[107] The Joint Committee staff recommends that in lieu of the uniform capitalization rules, costs incurred in producing property or acquiring property for resale should be capitalized using U.S. generally accepted accounting principles for purposes of determining a foreign person's earnings and profits and subpart F income. The uniform capitalization rules would continue to apply to foreign persons for purposes of determining income effectively connected with a U.S. trade or business. The recommendation would relieve taxpayers and the IRS from the compliance and enforcement burdens associated with applying the uniform capitalization adjustments in the context of certain foreign activities.

Secondary withholding tax

[108] The Joint Committee staff recommends that the secondary withholding tax with respect to dividends paid by certain foreign corporations should be eliminated. The recommendation would spare taxpayers the burden of having to understand and comply with rules that have limited applicability, and relieve the IRS of the difficult task of trying to enforce the tax against a foreign corporation with little or no assets in the United States.

Tax on certain U.S.-source capital gains of nonresident individuals

[109] The Joint Committee staff recommends that the 30-percent tax on certain U.S.-source capital gains of nonresident individuals should be eliminated. The recommendation would spare nonresident individuals with U.S. investments the burden of having to understand and comply with a rule that has limited applicability.

Treaties

[110] The Joint Committee staff recommends that the Secretary of the Treasury should update and publish U.S. model tax treaties at least once each Congress. The recommendation would help inform potentially affected taxpayers of the Administration's current treaty policy goals, afford affected taxpayers the opportunity to offer more helpful commentary to treaty policy makers, and enable affected taxpayers to make more informed assessments regarding investments in countries in which treaty negotiations are being carried out.

[111] The Joint Committee staff recommends that the Treasury should report to the Congress on the status of older U.S. tax treaties at least once each Congress. The recommendation would establish a process for renewing older U.S. tax treaties that may not reflect current policy and that provide different tax outcomes than do more recent U.S. tax treaties. Timely updates of U.S. tax treaties would reduce complexity that may arise for taxpayers and tax administrators as any one taxpayer may be subject to multiple different tax regimes on otherwise similar transactions by reason of the transactions involving different taxing jurisdictions with different treaties.

11. Tax-exempt organizations

Grass-roots lobbying

[112] The Joint Committee staff recommends that the separate expenditure limitation on grass-roots lobbying by certain tax-exempt organizations should be eliminated. Eliminating this limitation would relieve charities making the section 501(h) election of the need to define and allocate expenses for grass-roots lobbying as a subset of total lobbying expenditures. This would simplify the Code and regulations by eliminating a largely unnecessary, but burdensome, process of definition and calculation.

Excise tax based on investment income

[113] The Joint Committee staff recommends that the excise tax based on the investment income of private foundations should be eliminated. The recommendation would relieve private foundations of having to calculate net investment income, to make estimated tax payments, and to consider whether annual charitable distributions should be increased or decreased because of the two-tiered nature of the tax. In addition, taxable foundations would not be required to calculate the unrelated business income tax they would have been required to pay if they were a taxable organization. Short of elimination, the tax could be revised to generate less revenue and at the same time become less complex, for example, by basing the tax on a percentage of the value of a private foundation's assets at the end of a taxable year.

12. Farming, distressed communities, and energy provisions

Conservation payments

[114] The Joint Committee staff recommends that the Code should be amended to reflect that the agricultural conservation program authorized by the Soil Conservation and Domestic Allotment Act has been replaced by the Environmental Quality Incentives Program. The recommendation would clarify that cost-sharing payments under the Environmental Quality Incentives Program are excludable from gross income.

Reforestation expenses

[115] The Joint Committee staff recommends that the separate seven-year amortization and tax credit for $10,000 of reforestation expenses should be replaced with expensing of a specified amount of reforestation expenses. Expensing could provide approximately the same tax benefit for qualified reforestation expenditures without requiring two distinct calculations and without requiring the additional recordkeeping to carry forward the taxpayer's unamortized basis in the expenditures through eight taxable years.

Sales of timber qualifying for capital gains treatment

[116] The Joint Committee staff recommends that (1) the sale of timber held more than one year by the owner of the land from which the timber is cut should be entitled to capital gain treatment and (2) the provision relating to a retained economic interest should be eliminated. The recommendation would eliminate the need to make subjective determinations of dealer status with respect to sales of timber and would eliminate a source of controversy and litigation.

District of Columbia ("D.C.") Enterprise Zone

[117] The Joint Committee staff recommends that, if the D.C. Enterprise Zone is to be extended for a significant period of time, then the poverty rates and the gross income thresholds applicable to the zero-percent capital gains rate should be conformed to the poverty rates and gross income thresholds that apply to the other tax incentives with respect to the D.C. Enterprise Zone. Thus, the Joint Committee staff recommends that a new business should qualify for the zero-percent capital gains rate if (1) more than 50 percent (rather than 80 percent) of its gross income is from the active conduct of a qualified business within the zone, and (2) the business is located in census tracts with at least a 20-percent (rather than 10 percent) poverty rate. The recommendations would eliminate much of the confusion, as well as traps for the unwary, for businesses that locate in the D.C. Enterprise Zone by providing a single gross income and single poverty test for determining whether a new business qualifies for the various tax incentives.

Tax incentives for business located in targeted geographic areas

[118] The Joint Committee staff recommends that a uniform package of tax incentives for businesses that locate in targeted geographic areas should be adopted. In addition, the targeted geographic areas that would be eligible for the tax incentives would be determined based on the application of a consistent set of economic measurements. The recommendation would eliminate many of the complexities that exist under present law for businesses in determining where to locate its business facilities, and for the Treasury, the IRS, and State and local agencies in selecting the distressed areas complying with the tax laws and monitoring the effectiveness of the tax incentives.

Geological and geophysical costs

[119] The Joint Committee staff recommends that taxpayers should be permitted immediate expensing of geological and geophysical costs. The recommendation would reduce complexity by eliminating the need to allocate such expenses to various properties and by eliminating the need to make factual determinations relating to the properties, such as what constitutes an area of interest and when a property is abandoned.

13. Excise taxes

Highway Trust Fund excise taxes

[120] The Joint Committee staff recommends that the number of taxes imposed to finance Highway Trust Fund programs should be reduced by eliminating or consolidating the non-fuels taxes. The rates at which the fuels taxes or the restructured non-fuels taxes are imposed could be adjusted to ensure that future funding for Trust Fund programs is not affected. Adoption of this recommendation would reduce the number of taxpayers having direct involvement with the highway excise taxes. Further, the non-fuels taxes are heavily dependent on factual determinations; their elimination would end numerous audit issues between taxpayers and the IRS.

[121] The Joint Committee staff recommends that the definition of highway vehicle should be clarified to eliminate taxpayer uncertainty about the taxability of motor fuels and retail sales (if the retail sales tax is retained). Enacting a single definition of highway vehicle would provide certainty to taxpayers.

[122] The Joint Committee staff recommends that the option to pay the heavy vehicle annual use tax in quarterly installments should be eliminated (if that tax is retained). Elimination of this payment option would increase compliance with the highway excise taxes while eliminating the need for tracking relatively small amounts of tax due from numerous taxpayers.

[123] The Joint Committee staff recommends that several technical modifications should be made to the present Code provisions governing motor fuels refund procedures and tax collection: (1) timing and threshold requirements for claiming quarterly refunds should be consolidated to allow a single claim to be filed on an aggregate basis for all fuels; (2) to the extent necessary to implement item (1), differing present-law exemptions should be conformed; (3) clarification of the party exclusively entitled to a refund should be provided in cases in which present law is unclear; (4) the regulatory definition of "position holder" (the party liable for payment of the gasoline, diesel fuel, and kerosene taxes) should be modified to recognize certain two-party terminal exchange agreements between registered parties; and (5) the condition of registration requiring terminals to offer for sale both undyed and dyed diesel fuel and kerosene should be eliminated. Consolidation and clarification of differing rules that affect similar transactions by taxpayers would provide certainty to taxpayers, as well as reducing needed IRS resources in administering these taxes.

Airport and Airway Trust Fund excise taxes

[124] The Joint Committee staff recommends that liability for the commercial air transportation taxes should be imposed exclusively on transportation providers.

[125] The Joint Committee staff recommends that the penalties for failure to disclose commercial air passenger tax on tickets and in advertising should be eliminated. Department of Transportation consumer protection disclosure requirements would remain in force for these as well as other currently regulated fees and charges.

[126] The Joint Committee staff recommends that a uniform, statutory definition of the tax base for the commercial air freight tax should be enacted with any exclusion for accessorial ground services being specifically defined. This recommendation would provide a level playing field for all air freight carriers, and also would eliminate numerous audit disputes that occur under present law.

[127] The Joint Committee staff recommends that the current definition of commercial air transportation, as applied to non- scheduled transportation, should be reviewed and, if appropriate, conformed to Federal Aviation Administration aircraft safety and pilot licensing regulations.

[128] The Joint Committee staff recommends that the present-law Code provisions governing aviation fuel refund and tax collection procedures should be coordinated with comparable rules for Highway Trust Fund excise taxes, if possible.

Harbor Maintenance Trust Fund excise tax and tax on passenger transportation by water

[129] The Joint Committee staff recommends that the Harbor Maintenance Trust Fund excise tax and the General Fund tax on passenger transportation by water should be eliminated. This recommendation would conform the Code to court decisions and U.S. international trade obligations.

Aquatic Resources Trust Fund excise taxes

[130] The Joint Committee staff recommends that the sport fishing equipment excise tax should be eliminated. The current tax requires excessive factual determinations and disadvantages some industry participants relative to manufacturers of similar, untaxed articles that compete in the marketplace.

Federal Aid to Wildlife Fund and non-regular firearms excise taxes

[131] The Joint Committee staff recommends that Federal Aid to Wildlife Fund and non-regular firearms excises taxes should be eliminated. If the taxes are retained, consideration should be given to (1) consolidating certain of the taxes and (2) changing the tax rates to fixed-amount-per-unit rates in lieu of the present ad valorem rate structure to reduce factual and tax-base issues arising under the current structure. Tax law simplification would be furthered if the dedicated taxes were repealed and the Wildlife Fund program financed with general revenue appropriations.

Black Lung Trust Fund excise tax

[132] The Joint Committee staff recommends that the Code provisions on exported coal should be modified to eliminate the provisions imposing tax on coal mined for export in light of a recent court decision holding that portion of the tax to be unconstitutional.

Communications excise tax

[133] The Joint Committee staff recommends that the present-law Federal communications excise tax should be eliminated. If the tax is not eliminated, the Joint Committee staff recommends that: (1) liability for the tax should be shifted to telecommunications service providers so that unpaid tax would be collected as part of regular bad debt collections; (2) the present Code provisions should be updated to reflect current technology; and (3) broad grants of regulatory authority should be provided to the Treasury to allow it continually to update the tax base to reflect future technological changes. Under present law, the communications tax does not reflect the state of technology in the industry, thereby giving rise to disparate treatment of different providers of similar services and requiring highly factual determinations as to when services are taxed.

Ozone-depleting chemicals excise tax

[134] The Joint Committee staff recommends that the ozone- depleting chemicals excise tax should be eliminated as deadwood in light of provisions of the Montreal Protocol and the Clean Air Act that significantly restrict the use of the chemicals subject to tax.

Alcohol excise taxes

[135] The Joint Committee staff recommends that the three separate excise taxes currently imposed on alcoholic beverages should be consolidated into a single tax, with the rate being based on alcohol content of the beverage. The Code provisions governing operation of alcohol production and distribution facilities similarly should be consolidated to the extent consistent with overall operation of Federal alcohol regulation laws.

[136] The Joint Committee staff recommends that, if the current three-tax structure is retained, the reduced rates for production from certain small facilities and for distilled spirits beverages containing alcohol derived from fruit should be eliminated. This recommendation would result in identical beverages being subject to the same tax rate, thereby eliminating economic advantages that currently flow to some, but not all, producers of the same product as well as reducing recordkeeping requirements on taxpayers.

[137] The Joint Committee staff recommends that the alcohol occupational taxes should be eliminated. These taxes are in the nature of business license fees and serve no tax policy purpose.

[138] The Joint Committee staff recommends that the rules governing cover over of rum excise taxes to Puerto Rico and the U.S. Virgin Islands should be consolidated to reduce Federal administrative resources required for this revenue-sharing program.

Tobacco excise taxes

[139] The Joint Committee staff recommends that the present excise taxes on pipe tobacco, roll-your-own tobacco, and cigarette papers and tubes should be consolidated into a single tax on pipe and roll-your-own tobacco.

[140] The Joint Committee staff recommends that the tax rate imposed on cigars should be modified to eliminate the ad valorem component. Adoption of this recommendation would reduce audit issues as to the correct tax base in transactions where the products are sold between manufacturers and related parties in the distribution system.

[141] The Joint Committee staff recommends that the tobacco occupational tax should be eliminated. This tax is in the nature of a business license fee and serves no tax policy purpose.

14. Tax-exempt bonds

Unrelated and disproportionate use limit

[142] The Joint Committee staff recommends that the unrelated and disproportionate use limit under which no more than five percent of governmental bond proceeds may be used for a private purpose that is unrelated to the governmental activity also being financed should be eliminated. The general limits on private business use of governmental bond proceeds, combined with the requirement that certain larger issues receive an allocation of State private activity bond volume authority, adequately restrict issuance of tax-exempt governmental bonds to situations in which a private party does not receive excessive benefit.

Prohibition on use of private activity bond proceeds for certain business

[143] The Joint Committee staff recommends that the prohibition on using private activity bond proceeds for certain business should be conformed for all such bonds and consolidated into one Code section. The multiple sets of rules for similar types of bonds create unnecessary complexity for taxpayers and the IRS.

Obsolete and near-obsolete provisions

[144] The Joint Committee staff recommends that the special qualified mortgage bond rules for residences located in Federal disaster areas, which have expired, should be eliminated as deadwood.

[145] The Joint Committee staff recommends that the temporary gubernatorial authority to allocate the private activity bond volume limits, which has expired, should be eliminated as deadwood.

[146] The current qualified mortgage bond and qualified veterans' mortgage bond programs substantially overlap. The Joint Committee staff recommends that only one mortgage interest subsidy -- qualified mortgage bonds -- should be provided through the issuance of tax-exempt private activity bonds. Consolidation of two similar provisions would reduce the need for duplicate administrative agencies and eliminate potential confusion among potentially qualifying beneficiaries and among potential lenders in those States that issue both qualified mortgage bonds and qualified veterans' mortgage bonds.

[147] The Joint Committee staff recommends that the $150 million limit for qualified section 501(c)(3) bonds should be eliminated as it relates to capital expenditures incurred before the date of enactment of the Taxpayer Relief Act of 1997. This limit was repealed in 1997 for capital expenditures incurred after enactment of the Taxpayer Relief Act.

[148] The Joint Committee staff recommends that the qualified small-issuer exception for certain bank-qualified bonds should be eliminated in light of the development since 1986 (when the rule was enacted) of State bond banks and revolving pools that provide needed market access for smaller governmental units without the bank subsidy provided by the exception. In addition, provisions of the Community Reinvestment Act now require banks to invest in local projects without regard to subsidies such as that provided by this exception. The elimination of this exception would help streamline the arbitrage rebate rules without disadvantaging qualified small-issuers.

Public notice requirement

[149] The Joint Committee staff recommends that the "public notice" requirement for a qualified private activity bond should be allowed to be satisfied by other media if the objective of reasonable coverage of the population can be met. For example, notice via the Internet in addition to radio and television would satisfy an expanded public notice requirement. The Joint Committee staff recommends that, in lieu of a public hearing, the public comment requirement should be satisfied by written response and Internet correspondence. The recommendation would reduce the compliance burden by offering issuers less costly ways to obtain public scrutiny of proposed bond issues.

Arbitrage rebate

[150] The Joint Committee staff recommends that the present-law construction period spend down exception should be expanded to 36 months with prescribed intermediate targets. Expanding the present- law construction period spend down exception to somewhat longer construction projects would expand the number of issuers who are not required to track temporary investments and compute arbitrage without creating excessive incentives to issue bonds in larger amounts or earlier than needed for governmental purposes in order to invest proceeds for profit.

[151] The Joint Committee staff recommends an increase to the basic amount of governmental bonds that small governmental units may issue without being subject to the arbitrage rebate requirement from $5 million to $10 million. Specifically, these governmental units would be allowed to issue up to $15 million of governmental bonds in a calendar year provided that at least $5 million of the bonds are used to finance public schools. This recommendation reflects the increased dollar costs of activities financed by smaller governments since the provision was enacted in 1986 without expanding the benefit beyond those smaller governments that often lack in-house accounting staff to perform needed investment tracking and arbitrage calculations.

15. Estate and gift tax

[152] The Joint Committee staff recommends that the qualification and recapture rules contained in the special-use valuation and the qualified family owned business provisions be conformed to the extent practicable. Uniform rules to the extent practicable would make these related estate tax benefits easier to understand and administer.

16. Deadwood provisions

[153] The Joint Committee staff recommends that out of date and obsolete provisions in the Code should be eliminated. The Joint Committee staff has identified more than 10 provisions that could be eliminated as deadwood.

II. MANDATE FOR STUDY AND JOINT COMMITTEE STAFF STUDY METHODOLOGY

A. STUDY MANDATE AND LEGISLATIVE BACKGROUND

1. Study mandate

In general

[154] The complexity of the present-law Federal tax system has received attention from commentators, tax practitioners, tax administrators, and legislators for many years. Indeed, this is not the first time the Joint Committee has been directed to conduct a study of the complexity of the Federal tax system. In 1926, the Congress, in establishing the Joint Committee, created a statutory responsibility in the Joint Committee to (1) investigate measures and methods for the simplification of Federal taxes, particularly the income tax, and (2) to publish, from time to time, for public examination and analysis, proposed measures and methods for simplifying Federal taxes. ² The first report of the Joint Committee was published in 1928. ³ In this report, the Joint Committee staff made the following observations about simplification:

In approaching the simplification of the income tax, two

. . . The relative importance of simplification depends upon the

Joint Committee on Taxation study of the overall state of the Federal tax system

[157] Under the Internal Revenue Service Restructuring and Reform Act of 1998 (the "IRS Reform Act"), the Joint Committee is required to report, at least once each Congress, to the Senate Committee on Finance and the House Committee on Ways and Means on the overall state of the Federal tax system. ⁸ This study is to include recommendations with respect to possible simplification proposals and such other matters relating to the administration of the Federal tax system as the Joint Committee may deem advisable.

[158] Preparation of the Joint Committee study is subject to specific appropriations by the Congress. For fiscal year 2000, the staff of the Joint Committee on Taxation ("Joint Committee staff") advised the House and Senate Appropriations Committees that an appropriation of $200,000 would be required for the Joint Committee staff to undertake the study and amounts were appropriated for this purpose. ⁹

[159] The legislative history of the IRS Reform Act does not include any additional discussion of Congressional intent with respect to the study. However, Congressional concerns about the complexity of the Federal tax system are evident in a number of provisions of the IRS Reform Act that originate from recommendations of the National Commission on Restructuring the Internal Revenue Service.

2. Legislative background

National Commission on Restructuring the Internal Revenue Service

[160] The National Commission on Restructuring the Internal Revenue Service (the "Commission") was created in 1996 to examine the organization of the Internal Revenue Service ("IRS") and to recommend actions to expedite the implementation of Tax Systems Modernization and improve service to taxpayers. ¹⁰ The Commission issued a final report on June 25, 1997. ¹¹ Many of the Commission's recommendations were enacted in the IRS Reform Act.

[161] The Commission found a clear connection between the complexity of the Internal Revenue Code (the "Code") and the difficulty of tax law administration and taxpayer frustration. The Commission report noted that the frequency with which tax laws change also compounds the problem of tax administration. According to the Commission report:

While the Commission recognizes that much of the tax law's

[163] The Commission report recommended that a framework should be established to provide a process by which the Congress and the President would consider tax simplification legislation in a systematic and regular manner. The Commission recommended that the Congress consider creating a quadrennial review of the tax law for simplification. The Commission report further recommended that the Joint Committee should undertake a review of the Code using a tax complexity analysis and should work with the Department of the Treasury ("Treasury"), the IRS, and taxpayers to review the tax law for provisions that may have outlived their original purpose or that have been superseded by other legislation. The Commission report also included proposals to simplify the tax law.

[164] The IRS Reform Act did not create a process for quadrennial review of possible simplification proposals. However, the IRS Reform Act imposed two statutory requirements on the Joint Committee with respect to simplification of the Federal tax laws: (1) this study; and (2) a tax complexity analysis to accompany certain legislation. In addition, the IRS Reform Act requires the Commissioner of Internal Revenue to report once each year to the Congress with respect to the sources of complexity in the administration of the Federal tax laws.

Joint Committee tax complexity analysis

[165] As noted above, the IRS Reform Act created a statutory duty for the Joint Committee (in consultation with the IRS and the Treasury) to prepare a tax complexity analysis for all legislation reported by the Senate Committee on Finance, the House Committee on Ways arid Means, and any conference committee if such legislation includes any provision that directly or indirectly amends the Code and has a widespread applicability to individuals or small businesses.

[166] The Joint Committee considers a provision to have widespread applicability to individual taxpayers if the provision is expected to affect 10 percent of individual return filers (approximately 13 million tax returns for 2001). The Joint Committee considers a provision to have widespread applicability to small businesses if the provision is expected to affect 10 percent of businesses with annual gross receipts of $5 million or less (approximately 2.6 million businesses for 2001). This definition of small business (annual gross receipts of $5 million or less) covers approximately 24 million businesses (sole proprietorships, partnerships, and corporations) or approximately 99 percent of all such businesses in the United States.

[167] The tax complexity analysis is required to include (1) an estimate of the number of taxpayers affected by a provision, and (2) if applicable, the income level of taxpayers affected by the provision.

[168] In addition, if determinable, the analysis is to include the following information:

(1) The extent to which tax forms supplied by the IRS would

Commissioner's study of tax law complexity

[170] The IRS Reform Act requires the Commissioner of Internal Revenue to conduct an annual analysis of the sources of complexity in the administration of the Federal tax laws. The Commissioner is required to report no later than March 1 of each year the results of its analysis to the Senate Committee on Finance and the House Committee on Ways and Means. The first Commissioner's report was issued on June 5, 2000. ¹⁴

National Taxpayer Advocate's annual report to Congress

[171] The IRS Reform Act requires the National Taxpayer Advocate to report once each year to the Congress. This report is required to include, among other things, a summary of at least 20 of the most serious problems encountered by taxpayers, including a description of the nature of the problem and an identification of areas of the tax law that impose significant compliance burdens on taxpayers or the IRS. The report of the National Taxpayer Advocate for fiscal year 2000 stated that complexity of the tax laws affecting individual is the most serious problem facing individual taxpayers. ¹⁵

B. JOINT COMMITTEE STAFF STUDY METHODOLOGY

[172] The following discussion outlines the methodology employed by the Joint Committee staff to review the overall state of the Federal tax system and the process by which the Joint Committee staff (1) identified provisions adding complexity to present law and (2) developed recommendations to simplify the law.

1. Review of the overall state of the Federal tax system

Review of prior simplification proposals

[173] The Joint Committee staff undertook an extensive study of prior simplification proposals. This study included review of legal and economic literature making simplification and other legislative recommendations during the past 10 years; prior published and unpublished work of the Joint Committee with respect to simplification; various published Treasury studies; materials published by the Taxpayer Advocate and the Commissioner of Internal Revenue, including the Tax Complexity Study issued by the Commissioner on June 5, 2000; and published simplification recommendations of various professional organizations, including the American Bar Association, the American Institute of Certified Public Accountants, and the Tax Executives Institute.

Advisors to the Joint Committee

[174] The Joint Committee staff assembled two groups of advisors to assist in the analysis of various simplification proposals and to solicit simplification ideas that may not have been previously advanced.

Academic advisors

[175] The Joint Committee staff convened a group of approximately 40 tax scholars (generally law school tax professors) with extensive experience relating to the Federal tax system. The Joint Committee staff held a series of meetings with these academic advisors, including a two-day meeting in June of 2000 and full day meetings in January and February of 2001. The academic advisors were asked by the Joint Committee staff to assist in identifying the areas of the Federal tax system in need of simplification, to suggest various simplification proposals, and to comment on simplification proposals raised by the Joint Committee staff. The academic advisors were given drafts of the Joint Committee staff recommendations for review and comment.

[176] A list of the Joint Committee academic advisors is contained in Appendix A.

[177] In the summer of 2000, the Joint Committee staff issued a call for papers to the academic advisors on topics relating to simplification of the Federal tax system. The papers that were submitted to the Joint Committee staff are published without comment in Volume III of this study.

[178] Three academic advisors served as consultants to the Joint Committee staff during the study. These advisors were asked to undertake in-depth analysis of certain of the issues under review by the Joint Committee staff.

Tax policy advisors

[179] The second group of advisors consisted of individuals who held high-level tax policy positions in the Federal government, listed in Appendix B. These individuals included former Commissioners of Internal Revenue and IRS Chief Counsels, former Treasury Assistant Secretaries for Tax Policy, and former Joint Committee Chiefs of Staff. The Joint Committee staff met with this group of advisors in May of 2000, consulted with these advisors on an informal basis, and invited the advisors to attend meetings with the Joint Committee staffs academic advisors.

Meetings with IRS

[180] In addition to reviewing materials relating to simplification prepared by the Commissioner of Internal Revenue and the Taxpayer Advocate, the Joint Committee staff conducted a full-day meeting with representatives of the IRS to solicit comment and suggestions on specific issues under the Federal tax system. In addition, Joint Committee staff met separately with the IRS and the Director of the American University Washington College of Law Tax Clinic on issues relating to the present-law earned income credit.

General Accounting Office

[181] The Joint Committee staff requested the General Accounting Office to provide information that would assist in measuring the effects of complexity on taxpayers. The Joint Committee staff asked the General Accounting Office provide information relating to the size of the Code, the number of forms, instructions, and publications, and taxpayer errors and requests for assistance to the IRS. Specifically, the Joint Committee staff asked the General Accounting Office to provide the following information:

(1) Number of sections or provisions in the Code, cross

Congressional Research Service

[183] The Joint Committee staff asked the Congressional Research Service to provide the following information:

(1) Significant legislative changes to the Code;

2. Identifying provisions adding complexity

[185] Complexity in the Federal tax laws takes different forms. The Joint Committee staff observed at least three general categories of complexity: computational complexity, transactional complexity, and drafting complexity.

[186] Computational complexity generally refers to calculations that are required to determine tax liability. Complex or numerous calculations increase both the time it takes for taxpayers to fill out returns and the likelihood of errors. The need to perform complex calculations may often lead taxpayers to hire tax professionals or purchase tax preparation software to assist in return preparation.

[187] Transactional complexity generally refers to the extent to which the tax laws complicate the planning and execution of transactions by taxpayers. Transactional complexity can result not only because the tax laws applicable to any particular transaction are complex, but also because there may be multiple provisions covering similar or related fact situations and each provision may generate a different tax result. Transactional complexity caused by multiple provisions may distort economic decision-making, thus causing taxpayers to structure transactions in a particular manner solely because of tax consequences.

[188] Drafting complexity generally refers to complexity that results from the way in which the tax laws are written. This type of complexity is likely to be an issue principally for tax practitioners. This type of complexity may make it harder for practitioners to understand the law, either because the law is not written clearly or because the relevant law on a particular issue is scattered throughout the Code. Drafting complexity may increase the time it takes tax practitioners to understand the tax law and also may increase the likelihood of incorrect interpretations of the law.

[189] In conducting this study, the Joint Committee staff looked at a variety of factors that contribute to complexity. Although the Joint Committee staff's focus was on complexity as it affects taxpayers (either directly or through the application of the law by tax practitioners), the Joint Committee staff also took into account complexity encountered by the IRS in administering the tax laws. The Joint Committee staff generally did not take into account the level of sophistication of taxpayers or the complexity of transactions in identifying complex provisions; however, as discussed below, this was a factor taken into account in making recommendations for simplification.

[190] Factors the Joint Committee staff analyzed in identifying provisions that add complexity include the following:

(1) the existence of multiple provisions with similar

Overriding criterion for simplification recommendations

[191] In developing possible simplification recommendations, the Joint Committee staff applied one overriding criterion: the Joint Committee staff would make a simplification recommendation only if the recommendation did not fundamentally alter the underlying policy articulated by the Congress in enacting the provision. Thus, when the Joint Committee staff considered a provision of present law that was identified as adding complexity, the Joint Committee staff asked whether the provision could be made simpler without altering the basic policy of the provision.

[192] This criterion led the Joint Committee staff not to make certain possible simplification recommendations. ¹⁶ For example, the distinctions in tax treatment under present law between capital gains and losses, and ordinary income and losses, give rise to significant complexity, but recommending changes to make the treatment more uniform would alter the underlying broad tax policy to favor investment in capital assets. The study includes a general discussion of provisions involving significant complexity but for which making a simplification recommendation would be inconsistent with the underlying policy.

[193] The Joint Committee staff did not reject simplification recommendations merely because the proposal may alter the class of taxpayers affected by a provision. For example, the Joint Committee staff recommends repeal of many of the phase-out provisions of present law because the same policy can be served more simply through the rate bracket structure. However, the Joint Committee staff recognizes that addressing the repeal of phase-outs through the rate structure will affect different taxpayers in different ways.

[194] In several instances, the Joint Committee staff concluded that a provision did not accomplish the underlying policy articulated when the provision was enacted. For example, the Joint Committee staff concluded that the individual alternative minimum tax now applies to significantly more taxpayers than was intended when the tax was enacted. In such instances, the Joint Committee staff concluded that recommending elimination or substantial modification of a provision was not inconsistent with the underlying policy.

Issues considered in developing simplification recommendations

[195] In analyzing any proposal to simplify the present-law Federal tax system, the Joint Committee staff considered a variety of issues, including:

(1) the extent to which simplification can be achieved by the

Achieving additional simplification

[197] The Joint Committee staff analyzed each possible simplification recommendation to determine whether the proposal would in fact result in simplification compared to present law. In some cases, although a proposal might simplify present law in some respects, other aspects of a proposal might add complexity compared to present law. The Joint Committee staff recommended a proposal only if the proposal would clearly result in simplification. For example, the Joint Committee staff analyzed the rules relating to worker classification, and decided not to make a recommendation. This decision was due in part because the Joint Committee staff determined that any recommendation would involve fundamental policy decisions. In addition, the Joint Committee staff was unable to determine that any of the proposals considered would clearly result in simplification, regardless of the policy implications.

Fairness

[198] The Joint Committee staff analyzed possible simplification proposals to ensure that they did not fundamentally alter the fairness of the present-law tax system. It is a generally accepted principle under the Federal tax system that taxpayers with similar amounts of income should pay similar amounts of Federal tax; this concept is referred to as horizontal equity.

[199] Achieving greater horizontal equity sometimes requires distinctions that increase complexity, for example, adjustments for family size and type of taxpayer. In addition, even though certain types of noncash income are difficult to value for purposes of taxation, taking account of such income arguably is necessary to achieve an accurate measure of ability to pay taxes and to maintain taxpayer confidence in the fairness of the system.

[200] Because the Joint Committee staff did not make recommendations that fundamentally would alter the intended policy of a provision, the Joint Committee staff analyzed each proposal to determine whether it maintained horizontal equity among taxpayers.

Understandability and predictability

[201] In analyzing possible simplification proposals, the Joint Committee staff evaluated whether any particular proposal would improve the understandability and predictability (i.e., transparency) of the Federal tax system.

[202] In order for similarly situated individuals actually to bear similar tax liability, a tax system must be understandable and the outcome of calculations must be predictable; otherwise, differences in liabilities will occur based solely on misunderstanding of the law. In addition, if a tax system is not transparent, tax liability may vary (without regard to ability to pay) for taxpayers who invest time and resources (e.g., investments in tax shelters) in understanding (and abusing) the system. Thus, in addition to other advantages, simplicity makes equal treatment of similarly situated taxpayers more likely by increasing the likelihood that people of equivalent profiles will pay equivalent amounts of tax.

Complexity of transactions

[203] In evaluating possible simplification recommendations, the Joint Committee staff considered the complexity of the transactions that would be covered by a particular recommendation. Some argue that the complexity of modem business transactions not only justifies, but necessarily requires, a complex set of Federal tax rules.

[204] For example, the Joint Committee staff considered recommending that the rules relating to corporate mergers and acquisitions be simplified. Commentators have written about the complexity of these rules and tax practitioners acknowledge that they are among the most complex rules in the present-law Federal tax system. However, many of the experts the Joint Committee staff consulted recommended retaining the corporate merger and acquisition rules. Some of these experts argued that (1) although the rules are complex, practitioners understand and work with them on a daily basis, and (2) the rules do not add complexity for individual taxpayers. Thus, the Joint Committee staff concluded that, although the rules relating to corporate mergers and acquisitions are complex and often require significant resources, the limited number of taxpayers who must use these rules are generally able to obtain sophisticated tax advice to assist them. As a result, no specific simplification recommendation relating to corporate mergers and acquisitions was included in the study.

Administrative feasibility and enforceability

[205] The Joint Committee staff considered whether a possible simplification proposal would improve the administration of the Federal tax system from the standpoint of taxpayers, tax practitioners, and the IRS.

[206] In making recommendations, the Joint Committee staff took into account the fact that taxpayers and tax practitioners prefer rules that minimize the recordkeeping and reporting burdens to the greatest possible extent. In addition, it is important for the IRS to be able to train its employees to understand and apply uniformly the Federal tax laws. Furthermore, the IRS must be able to prepare clear and timely forms and instructions, taxpayer publications, and other forms of published guidance.

Burdens imposed by changes in the law

[207] Frequent changes in the Federal tax laws contribute to complexity for taxpayers, tax practitioners, and tax administrators, who must all become familiar with the new provisions. New provisions require the IRS to retrain employees, modify forms and instructions, issue new guidance, and reprogram computers. The adoption of a simplification proposal could impose similar burdens on taxpayers, tax practitioners, and tax administrators.

[208] The Joint Committee staff did not make a-recommendation for simplification if the burdens imposed by the change were not justified by the possible simplification achieved. For example, the rules relating to employer-sponsored retirement plans are among the most complex in the Code. Some commentators have suggested that the present-law rules be replaced with a set of rules specifying model plans and provisions that must be used by employers that choose to adopt a plan. In addition to determining that such an approach would change fundamental policy, the Joint Committee staff determined that such a change would impose significant burdens on plan participants, employers, and the IRS in order to transition from present law to a new system.

Duplicative and obsolete provisions

[209] Complexity is added to the present-law Federal tax system by provisions that are out of date, duplicative, or obsolete. Thus, the Joint Committee staff reviewed the Code for provisions that could be updated, or could be repealed as deadwood. Deadwood provisions are listed in a separate section of the Joint Committee staff recommendations.

PART TWO. -- OVERALL STATE OF THE FEDERAL TAX SYSTEM

I. BACKGROUND INFORMATION ON THE FEDERAL TAX SYSTEM

[210] This section contains background information on the sources of Federal tax law and data concerning the filing of tax forms, taxpayer assistance, and information on error rates and tax controversies. The Joint Committee staff asked the General Accounting Office and the IRS to collect information that would assist the Joint Committee staff in evaluating the overall state of the Federal tax system. Some of that data is presented below.

A. SOURCES OF FEDERAL TAX LAW

The Internal Revenue Code

[211] The Code is the statutory underpinning of the Federal tax system. Along with related documents, the Code is the cumulative official expression of Federal tax law. The Code includes direct or indirect contributions from all three branches of government, and it has been overhauled comprehensively several times while growing in length. While the Code provides the statutory record and guide for understanding the Federal tax system, a fuller understanding of that system requires investigation of other materials and resources, including the regulations, the various types of administrative guidance (including informal taxpayer assistance), and judicial opinions. Nevertheless, a survey of the structure of the Code is one starting point for evaluating the overall state of the Federal tax system.

[212] The primary source of tax rules is the Internal Revenue Code of 1986, which superseded the Internal Revenue Code of 1954, which superseded the Internal Revenue Code of 1939. Prior to 1939, Federal tax statutes were not codified. Sections of the Code are revised frequently by acts of Congress. The Code contains both substantive law and the procedural rules applicable to tax controversies. Table 1.1 in Appendix C presents a breakdown by the General Accounting Office of the sections of the Code as they apply to three types of taxpayers: (1) individuals (693 sections); (2) businesses, including businesses of all sizes, and self-employed individuals (1,501 sections); and (3) tax-exempt organizations, employer-sponsored plans for employees, and government entities (445 sections). ¹⁷ This classification scheme is inclusive, so that provisions that affect more than one type of taxpayer are classified in more than one category.

[213] This classification of Code sections by type of taxpayer is not definitive because it does not attempt to grade the complexity of each section, but the enumeration does suggest several issues. First, there are a substantial number of provisions in almost every category, and this multiplicity should be considered with the recognition that single Code sections often engender significant complexity. Second, the almost 700 sections affecting individuals support the view that complexity in the Federal tax system is not limited to complex business activities. Third, the relationship of the numbers in Table 1.1 to complexity is not necessarily straightforward or additive. For example, it may be that two sections cause more than twice as much complexity as one section, given the natural cognitive limitations faced by taxpayers as they attempt to absorb additional information.

[214] Other General Accounting Office calculations indicate the Code's breadth. As of May 2000, the Code contained 1,395,028 words, excluding notes and cross-references added in publication. In addition, the Code is not a static document but instead requires continuing interpretation either directly through statutory modification or indirectly through regulatory and other means.

Treasury regulations

[215] The second principal source of tax rules is Treasury Regulations. Regulations are written largely by the office of the chief counsel of the IRS and the office of tax policy of the Treasury. There are three types of regulations: proposed, temporary and final. The publication of a regulation is accompanied by a "Treasury Decision," which provides a general overview of the reasons for, and provisions of, the regulation. Most regulations are issued first in proposed form in the Federal Register. Proposed regulations permit interested members of the public opportunities to comment on the regulations and suggest changes. Courts generally find that proposed regulations have no weight, but will sometimes refer to them if no other guidance is available. Some regulations remain "proposed" for many years. For example, the corporate sponsorship regulations under section 513 were proposed in January 1993 and remained proposed until new proposed regulations were released in March 2000.

[216] When a need for guidance precludes the more time-consuming notice-and-comment procedure, temporary regulations may be issued. Temporary regulations also are issued automatically as proposed regulations and expire three years after they are issued.

[217] A proposed or temporary regulation may be republished, often with modifications, as a final regulation. If changes are made to the proposed or temporary regulation, Treasury can finalize the regulation with amendments or repropose the regulation in amended form. Final regulations are presumed to have retroactive effect but Treasury can make the regulation prospective only. ¹⁸

[218] Most regulations are issued under the authority of section 7805(a) of the Code and are called "interpretive regulations." Courts generally defer to interpretive regulations if they are a reasonable implementation of the statute. If Congress provides an express authorization for Treasury to write regulations, e.g., sec. 385(a) ("The Secretary is authorized to prescribe such regulations as may be necessary or appropriate . . ."), such regulations are called "legislative regulations." Courts give legislative regulations even greater deference than interpretive regulations and generally overturn them only if they are plainly inconsistent with the statute. As of June 2000, the General Accounting Office calculated that the IRS had issued almost 20,000 pages of regulations containing over eight million words. ¹⁹ During the calendar year 2000, the IRS published 60 Treasury Decisions containing temporary and final regulations, and 45 sets of proposed regulations. Most of the effective dates of the final and temporary regulations were the dates they were published in the Federal Register, though a few had effective dates that related to other dates. ²⁰ Most of the proposed regulations had prospective effective dates. Most of the year 2000 regulations derived from 1996 and 1997 legislation, though some related back to 1976 and 1982 legislation.

IRS administrative guidance

[219] In addition to the Code and the regulations, there are numerous forms of administrative guidance published by the IRS. Revenue Rulings are subject to high-level review within the IRS and set forth the IRS's substantive legal position on an issue, typically as applied to a specific set of facts. In proceedings before the IRS, taxpayers may rely on Revenue Rulings. In litigation, Revenue Rulings do not have the force of law but courts generally consider them as indicative of the IRS's position and may find them binding on the IRS. Private Letter Rulings are issued at the request of a taxpayer when a taxpayer wants to know the tax consequences of a particular transaction. A Private Letter Ruling may be relied on only by the requestor of the ruling. Private Letter Rulings are not subject to high-level review and may not be cited as precedent. ²¹ The IRS will not issue Private Letter Rulings in certain areas. Technical Advice Memoranda are virtually identical to Private Letter Rulings except Technical Advice Memoranda can be requested either by the taxpayer or by the IRS but only in connection with an IRS proceeding. Revenue Procedures generally involve mechanical rules, for example, rules detailing how to make an election or how to apply for a Private Letter Ruling. IRS substantive positions are sometimes embedded in a Revenue Procedure.

[220] At a taxpayer's request, the IRS issues Determination Letters, which tell a taxpayer whether the taxpayer qualifies, for example, as a tax-exempt organization under section 501(c) or as a qualified plan under section 401. General Counsel Memoranda are prepared by the IRS General Counsel's Office, usually in connection with a Private Letter Ruling or Revenue Ruling. They are typically detailed considerations of the law, and although they transmit the reasoning of the IRS on an issue, they are not binding on the IRS and are not issued with the corresponding ruling. Other forms of guidance include Notices (similar to a press release), Announcements (also similar to a press release), Field Service Advice (advice from the National Office to an agent performing an audit in the field) and Actions on Decision or Acquiescences (statements issued after IRS loses a tax case in the courts as to whether IRS will continue with its litigating position in future cases). As discussed in Section I.B. of this Part, the IRS also provides guidance to taxpayers in its numerous publications and form packages.

[221] In the year 2000, the IRS published 58 Revenue Rulings, 49 Revenue Procedures (IRS reissues certain standard Revenue Procedures each year, sometimes with minor changes), 64 Notices, 100 Announcements,/22/ no General Counsel Memoranda, at least 2400 Private Letter Rulings and Technical Advice Memoranda, 10 Actions on Decision, and 240 issuances of Field Service Advice. Between the calendar years 1990 and 1998, IRS published 739 Revenue Rulings, 633 Revenue Procedures, 514 Treasury Decisions, 505 Proposed Regulations, 622 Notices, and 114 Announcements (which were all in 1998).

Table 1. Guidance Published by the IRS, 1990-1998/23/

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Table 2. Guidance Published by the IRS, 1990-1999/24/

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[223] Another source of guidance is judicial opinions. Different courts hear tax cases depending on the nature of the suit and the choice of the taxpayer. ²⁵ A deficiency action must be filed in the Tax Court, whereas a refund action must be filed either in the Federal Court of Claims or local Federal District Court. Tax Court decisions generally are appealable to the Federal Circuit Court in which the taxpayer resides. Accordingly, under the so-called Golsen rule,/26/ the Tax Court applies the law of the Circuit to which the case is appealable. Court of Federal Claims decisions are appealable to the Federal Circuit. District Court decisions are appealable to the Circuit Court in which the District is part. Decisions from the Circuit courts are appealable by writ of certiorari to the U.S. Supreme Court, which is granted rarely.

IRS forms and publications

[224] The General Accounting Office reports that for 1999 the IRS provided: 649 forms, schedules, and separate instructions totaling more than 16,000 lines; 159 worksheets; and over 300 publications with guidance on specific requirements of the tax system. ²⁷ There is great variety in length and complexity of this guidance, with some instructions limited to one or a few pages (e.g., Form 1040-V, Payment Voucher) and others of some length (e.g., Form 1041, U.S. Income Tax Return for Estates and Trusts, and related schedules). For 1999, a taxpayer filing an individual income tax return could be faced with a return (Form 1040) with 79 lines, instructions for the return totaling 144 pages, 11 schedules totaling 443 lines with instructions, and 19 separate worksheets embedded in instructions. ²⁸ In addition, the taxpayer may be required to file additional forms, such as Form 2441, Child and Dependent Care Expenses, and Form 8812, Additional Child Tax Credit. IRS Publication 17, Your Federal Income Tax, lists 18 forms commonly used by individual taxpayers other than Form 1040 and its schedules.

B. INFORMATION RELATING TO THE FILING OF THE FORMS

[225] The compliance effort required of taxpayers, and the IRS administrative effort, depends on the type of tax. Taxes that are largely withheld at the source or collected upon sale require different, often more limited, taxpayer responses than those that require individual taxpayers to monitor income or wealth over time. Separate requirements are imposed on businesses and others to act as intermediate collection agents for various Federal taxes.

[226] IRS data show that over 100 million individual income tax returns are filed annually on behalf of roughly 90 percent of the U.S. population. Corporations file about five million returns annually, and about two million partnership returns are filed annually on behalf of about twenty million partners. In addition, nonprofit charitable organizations exempt from income tax under section 501(c)(3) filed almost 200,000 information returns in 1997. ²⁹

[227] Several changes occurred during the last decade within and among these broad categories of filers. A growing percentage of business receipts are now covered by tax returns filed by subchapter S corporations and partnerships. Schedule D usage on individual returns increased over the 1990-1997 period. At the same time, the number of taxpayers who itemized their deductions on Schedule A remained relatively stable.

[228] Another taxpayer response is the usage of paid preparers. As discussed in Section III below, the usage of paid preparers can be attributed to many factors. As the General Accounting Office data in the Appendix show, the percentage of returns using paid preparers grew between 1990 and 1997. ³⁰ Among groups of taxpayers using paid preparers, there was a noticeable increase in such usage by non- itemizing individual taxpayers. This increased usage of paid preparers by non-itemizers may be partially attributable to the expansion of the Earned Income Credit.

[229] Sales information on tax return preparation software and electronic filing in the 1990s confirm that tax return filing is moving away from the traditional pen-paper-mail approach of the past and toward a computer-assisted method. The modest growth in these areas in the early 1990s seemed to accelerate as the decade ended. ³¹

C. TAXPAYER ASSISTANCE PROVIDED BY THE IRS

[230] While taxpayers may receive assistance from many sources, the IRS provides assistance to taxpayers through responses to taxpayer-initiated contacts. The General Accounting Office has obtained information on three types of contacts between the IRS and taxpayers: (1) correspondence; (2) walk-ins; and (3) telephone. Table IV.6 in Appendix C indicates that there are over 100 million annual taxpayer contacts with the IRS under these three methods, with most contacts consisting of telephone calls. Compared with the individual income tax return data presented below, the IRS is on average contacted roughly once per year per individual income tax return. This data does not indicate whether the IRS telephone response is automated or human, but it is likely that many telephone calls involve taxpayers listening to pre-recorded IRS messages, including checking on the status of income tax refunds. The data in Table IV.6 of Appendix C does not cover contacts with the IRS Internet website, a relatively recent outlet. Some Internet contacts are likely to substitute for other contacts, while other Internet contacts will likely stimulate the more traditional contacts listed in Table IV.6.

[231] Table IV.7 in Appendix C shows two forms of specialized assistance provided or sponsored by the IRS, the Tax Counseling for the Elderly and Volunteer Income Tax Assistance programs. Together these programs result in about three million annual person-to-person contacts.

D. ERROR RATES AND TAX CONTROVERSIES

[232] Errors and tax controversies can be caused by many factors. Complexity is one of these factors. The Joint Committee staff asked the General Accounting Office to examine data relating to taxpayer errors and tax controversies. The aggregate statistics presented below provide a starting point for examining the relationship between complexity and mistakes and disputes. ³²

Error rates

[233] The errors committed by individuals on their income tax returns, tabulated by the IRS for 1999, are summarized in Table V.3 in Appendix C. This table generally indicates that individual taxpayers had difficulties with the earned income credit and the child credit, the former being more of a problem for 1040-A and 1040- EZ filers and the latter causing difficulties for 1040 filers. The child credit is relatively new and the earned income credit has been significantly changed in recent years, so it is unclear whether the difficulties experienced by taxpayers in the late 1990s will subside over time. For individual taxpayers filing Form 1040, calculations of capital gain income and taxable Social Security benefits are prone to error, and both areas were changed by tax legislation enacted in the 1990s. The fact that many of the items on the common error list are associated with recent law changes gives some credence to the possibility of a relationship between legislative change and complexity.

[234] As an example of what private practitioners view as areas prone to taxpayer error, the list "How to Avoid 25 Common Errors," prepared as guidance for individual income taxpayers in the Ernst & Young tax guide largely corroborates the error list compiled by the IRS. ³³ The Ernst & Young list is not an error count and is not intended to be statistically valid, but it does represent the accumulated experience of a group of professionals who are paid to provide advice and prepare returns. Most of the items on the Ernst & Young list involve record-keeping and numerical inconsistencies.

Tax controversies

[235] The audit, appeals, and litigation information provided to the General Accounting Office by the IRS suggests that earned income credit and IRA issues are often sources of controversy between the IRS and taxpayers. With respect to business taxpayers, the definition of gross income and what constitutes a trade or business are among the items that cause continuing controversy, as well as self- employment issues. Survey data on some other areas of potential controversy, such as trust returns, is based on a limited sample or is not specific enough to pinpoint issues.

[236] Although it is currently unavailable, a measure of the outcomes of audit, appeal, and litigation would also be useful. If the incidence of tax controversies is connected to complexity, and the outcomes of complexity-associated disputes could be evaluated, then a truer measure of the cost of complexity, for both the IRS and taxpayers, could be obtained. ³⁴ Such information, should it become available, would permit a distinction between "acceptable" complexity, that is, unavoidable complexity that is a result of the application of necessarily complex business or other rules, and "unacceptable" complexity, which might be, for example, the product of inconsistent sections of the Code, or even inconsistencies within the same section of the Code. Complexity also might be less objectionable if it is transitional, such as the complexity caused by a statutory change to a well-established section of the Code, as opposed to a more permanent type of complexity associated with a more historically stable section of the Code.

II. SOURCES OF COMPLEXITY IN THE PRESENT-LAW FEDERAL TAX SYSTEM

A. OVERVIEW

[237] In the course of the study, the Joint Committee staff identified various sources of complexity in the present-law Federal tax system. No single source of complexity is primarily responsible for the state of the present-law system. Rather, the Joint Committee staff found that, for any complex provision, a number of different sources of complexity might be identified.

[238] Among these sources of complexity were (1) a lack of transparency in the law, (2) the use of the Federal tax system to advance social and economic policies, (3) increased complexity in the economy, (4) the interaction of Federal tax laws with State laws, (5) the interaction of Federal tax law with other Federal laws and standards, and (6) the interaction of Federal tax laws with the laws of foreign countries and tax treaties. As discussed below, the lack of transparency in the law results from a variety of factors, including (1) statutory language that is, in some cases, overly technical and, in other cases, overly vague, (2) too much guidance with respect to certain issues and too little guidance with respect to others, (3) the use of temporary provisions, (4) frequent changes in the law, (5) grants of regulatory authority, (6) judicial interpretation of statutory and regulatory language, and (7) the Congressional budget process.

B. LACK OF TRANSPARENCY IN THE LAW

In general

[239] The language of the law itself is a source of complexity in tax law. Speaking about the tax Code of 1939, Learned Hand wrote:

In my own case the words of such an act as the Income Tax, for

Statutory (and regulatory) language

[240] In general, the language and approach of the Code and the regulations is technical, abstract, detail-oriented, replete with cross-references and often aimed at an audience of experts and not the individual taxpayer.

[241] Code sections typically begin with a statement of the general rule. However, the general rule is an ineffective indicator of the law in many cases because in subsections after the general rule, exceptions and special rules typically follow. For example, the general rule of section 163(a) provides that "There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." Clearly, under the general rule, an individual taxpayer's car loan interest is deductible. The rule disallowing such "personal interest" does not appear until subsection 163(h), after subsections that provide rules for installment purchases, redeemable ground rents, limitation on investment interest, original issue discount, denial of deduction for interest on certain obligations not in registered form, and a reduction of deduction where the section 25 credit is taken. "Personal interest" then is defined by six headings and seven crossreferences. Assuming the taxpayer, who also is a homeowner, persevered to learn that personal interest was not deductible, the taxpayer might not have noticed the exception to the disallowance of personal interest for "qualified residence interest," provided in some detail by section 163(h)(3), i.e., the mortgage interest deduction. Complication of this kind occurs throughout the Code and the regulations.

[242] Although complexity in explication often is unavoidable, if the language is vague, dependent on defined terms, or circular, it is hard even for tax professionals to understand. For example, section 72 covers annuities and the treatment of proceeds from endowment and life insurance contracts. Section 72 utilizes 23 subsections and thousands of words. The final subsection, 72(w), provides simply: "For limitation on adjustments to basis of annuity contracts sold, see section 1021." This is a good example of the use of a cross-reference that complicates the Code. Section 1021 is straightforward: "In case of the sale of an annuity contract, the adjusted basis shall in no case be less than zero." Section 72(w) could have provided exactly what is contained in section 1021, eliminating the need for the reader to look to another section. As discussed in Section VIII.D. of Part Three of this study, the complexity of section 72 results in part from frequent amendment. ³⁷ Thus, in this and other cases, the legislative process contributes to complexity in statutory language because statutory sections often are revisited and there may not be time to reorganize the affected provisions in a logical format.

[243] Solutions to statutory complexity could include use of preambles describing the provisions and use of explanatory headings that alert the reader immediately whether a provision is relevant. ³⁸ Similar techniques could be used to simplify the regulations, for example, making more frequent use of tables of contents, clearly identifying safe harbors and exclusions, incorporating preambles from Treasury Decisions, avoiding undefined terms of art, and more experimentation with other formats, such as question and answer formats. ³⁹ As discussed in more detail at section IV of this Part below, other countries have found the language of their tax laws to be a significant source of complexity and have sought literally to rewrite the law in more user-friendly language, making use of general statements of purpose, explanatory materials and a more logical organization.

Too much guidance; too little guidance

[244] In tandem with the complexity caused by the language of the law is the complexity caused by the amount and variety of guidance. Many commentators have cited too much law and too detailed regulations as a major cause of complexity in the tax law. ⁴⁰ Regulations for a single Code section often run to tens and sometimes hundreds of pages and serve as models of complexity. ⁴¹ Even if such regulations succeed in resolving some issues they often are too cumbersome for practitioners or taxpayers with relatively simple issues.

[245] The regulations to section 469 on passive activity losses serve as an example of too much guidance, brought on in part by demands from practitioners. Section 469 was enacted in 1986 to combat tax shelters. The statute was fairly comprehensive, addressed the most likely circumstances, and was supported by extensive legislative history detailing the purposes of the legislation and the issues of concern. Yet demands for guidance as to the meaning of "activity" and "material participation" led to a regulations project that spawned 250 pages of regulations concerning "operating rules" for section 469 and 180 pages of regulations defining "activity" (including a twenty- two-step test) and clarifying other rules. Additional regulations also were issued. The result was more than 500 pages of regulations issued over a six-year period. To improve clarity, the regulations defining "activity" (which were temporary) were allowed to expire and replaced with a simpler set of rules permitting taxpayers to use any "reasonable" definition of activity, consistently applied.

[246] Alternatively, too little guidance also is a source of complexity. According to Treasury's November 2000 semi-annual regulatory agenda, 349 regulations projects were outstanding as of November 30, 2000. Lack of guidance or delays in issuing guidance promotes uncertainty for taxpayers and tax administrators. Taxpayers have difficulty planning transactions if definitive rules have not been prescribed. Lack of guidance also may lead to inconsistent enforcement and increased litigation. Incomplete guidance, e.g., guidance that leaves major issues unresolved, also contributes to complexity.

[247] As a compromise between too much and too little guidance, some have suggested the use of open-ended standards like "reasonableness" instead of precise, but voluminous, standards. A reasonableness standard does not provide concrete guidance and may frustrate those who require certainty because an answer to a legal question often comes down to an exercise of judgment: Is the questioned practice reasonable or not? If the law relies too much on vague standards, arguably the law is more complex because it lacks certainty. Vagueness also may lead to inconsistent enforcement and, in some cases, may place too much of a burden on taxpayers to make judgments. However, demands for guidance from practitioners due to reluctance to make judgments based on reasonable practices should not be a reason for issuing guidance where reasoned judgment may be preferable. If the alternative to a general legal standard is lengthy detailed guidance, complexity also is a result. More detail may successfully provide guidance in some situations, but the mere existence of the details hinders transparency. Perhaps more importantly, detail often creates additional ambiguity. Even the most prescient and careful drafting cannot foresee all relevant circumstances. "Elaboration in drafting does not result in reduced ambiguity. Each elaboration introduced to meet one problem of interpretation imports with it new problems of interpretation. Replacing one bundle of legal words with another bundle of legal words does not extinguish debate, it only shifts the terms in which the debate is conducted."/42/

[248] Complicating matters further, commentators note the frequency with which the Code and regulations resort to standards such as "reasonable" and to facts and circumstances tests while simultaneously offering a detailed bright line rule. The interaction of both sorts of tests does not advance simplicity. ⁴³ For example, "no substantial part" of a section 501(c)(3) organization's activities may be lobbying. The "no substantial part" test requires a judgment of how much is too much, which, though not precise, might not be unreasonably complicated. In addition, however, section 501(h) provides an alternative to the no substantial part test for organizations that make a special election. The 501(h) election subjects organizations to a precise catalog of spending limits on lobbying activity, which are set out in regulations. The existence of multiple ways to satisfy a given rule leads taxpayers to apply all options to decide which one they prefer, sometimes with little difference in outcome.

[249] Another sort of complexity results from guidance provided by the IRS in the private letter ruling process. The IRS issues thousands of private letter rulings each year to taxpayers. Many are a response to legitimate uncertainty. But some, so-called "comfort" rulings, seek rulings on areas of settled law, resulting in hundreds of rulings each year. ⁴⁴ For example, taxpayers regularly submit rulings on whether the merger or transfer of assets of a private foundation to another private foundation qualifies as a section 507(b)(2) transaction and if so whether the section 507 termination tax applies. The statute and regulations on this point are clear, but nevertheless practitioners ask for, and the IRS gives, rulings. Not only are administrative resources tested and the quantity of issued guidance increased, but settled law may be undermined by creating the appearance of ambiguity in the law.

[250] In short, guidance issued by the IRS and the Treasury is essential to effective administration of the Federal tax system. But some types of guidance also contribute to the complexity of the tax law.

Use of temporary provisions

[251] By their nature, temporary provisions cause uncertainty for taxpayers. In 2001, 12 provisions are scheduled to expire; in 2002, three provisions; in 2003, 12 provisions; in 2004, three provisions; in 2005, eight provisions; in 2007, eight provisions; and in 2009, 10 provisions. Most expiring provisions have been extended several times.

[252] In some cases, temporary provisions originally were enacted because the Congress articulated concerns about the underlying policy of the provision. However, in many instances, provisions were enacted on a temporary basis or were extended for a temporary period to satisfy revenue constraints. ⁴⁵

[253] The practice of extending temporary provisions for another "temporary" period creates significant uncertainty for taxpayers. It invites speculation as to whether every temporary provision will be extended. For example, the exclusion from income for employer- provided group legal assistance was enacted on a temporary basis in 1976, was extended seven times, and was allowed to expire after June 30, 1992. Similarly, the exclusion from income for employer-provided educational assistance has been extended ten times since its original enactment in the Tax Reform Act of 1978, was allowed to expire after 1994 and then retroactively was reinstated in 1996, and has at times applied to undergraduate education only, and at other times to graduate education and undergraduate education.

Frequent changes in the law

[254] Since the 1954 Code, over 500 public laws have made changes to the tax law. ⁴⁶ The rate of change is steady: nine public laws in the 106th Congress, 12 public laws in the 105th Congress, 14 public laws in the 104th Congress, 16 public laws in the 103rd Congress, 19 public laws in the 102nd Congress, and so on. ⁴⁷ Changes are both major and minor, and each public law typically involves changes to several Code sections covering a number of different areas of the Code. ⁴⁸ Major reform efforts, such as the Tax Reform Act of 1986, are preceded by smaller but significant changes to many provisions of law, such as the Economic Recovery Tax Act of 1981, and followed by more changes, such as the Technical and Miscellaneous Revenue Act of 1988. Unsettling change occurs when provisions are repealed shortly after their enactment. For example, the Tax Reform Act of 1986 enacted new section 89 to the Code, which replaced a facts and circumstances test with detailed bright line non-discrimination rules for certain employee benefit plans. Employers and others identified a variety of concerns associated with section 89, including excessive administrative burdens. In 1989 Congress repealed section 89 retroactively so that it never took effect. Changing the law by enacting section 89 added complexity to the substantive law; the subsequent repeal, even if sensible in this case, contributed to the climate of uncertainty and unpredictability of the law that is caused by other frequent changes.

[255] The rule of law depends on rules that are clear and definite. Frequent changes to the law create an impression of uncertainty. Taxpayers, and to a certain extent administrators, have less incentive to learn the rules or to rely on them. If repeated changes to law are for the purpose of improving fairness or accuracy, a subtle disincentive to learn or comply with each set of rules arises if future rules are anticipated to be better.

Grants of regulatory authority

[256] One source of complexity is Congressional delegation of regulatory authority to Treasury. For example, section 385 of the Code covers the "treatment of certain interests in corporations as stock or indebtedness." A person attempting to classify an interest in a corporation as stock or debt would consult section 385, which provides in section 385(a) only that "The Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or as in part stock and in part indebtedness)." Section 385(b) makes the delegation somewhat more specific, directing the Secretary to set forth factors to be considered in determining whether a creditor-debtor relationship or a corporation-shareholder relationship exists, and listing five factors that the Secretary "may" want to include. ⁴⁹ Such broad grants of regulatory authority in the statute creates complexity by providing uncertainty to taxpayers if regulations have not been issued.

[257] Such delegation of authority to the Treasury is consistent and widespread. The Congressional Research Service prepared a list of over 240 examples of delegation of regulatory authority by the Congress to Treasury from 1992 through 2000, an average of more than 26 delegations per year. ⁵⁰ The phraseology of delegation differs. Congress often provides that Treasury shall issue regulations "as may be necessary to carry out the purposes" of the section. ⁵¹ Another common form is to set out a rule that applies "except as otherwise provided by regulations. ⁵² In either case, the effect is explicitly to leave the details of the law unresolved. The practice is so common that it seems unremarkable, yet as a practical matter it leads to a situation in which the statute, the primary source of law, increasingly states only a general rule. Taxpayers cannot rely on the statute because the statute does not state a rule.

[258] As a general matter, simplicity would be improved if more statutory sections were self-executing, that is, do not require regulations to be effective or understood. Self-executing provisions do not preclude Treasury from promulgating interpretive regulations to fill in gaps. And, instead of regulating in a vacuum, with self- executing provisions, Treasury has the flexibility to identify the issues that require attention and formulate an appropriate measured response as the meaning of the provision is worked out in practice. Treasury can still be relied on to formulate the necessary details of a provision, but to the extent that the statute is not dependent on Treasury for its effect, taxpayers know in general what the law is, even if aspects of the law remain uncertain.

Judicial interpretation

[259] Courts regularly interpret the law in the process of deciding how the law applies to a set of facts. Not only does case law create an additional source of law (that may differ among jurisdictions), which increases complexity, but the manner of a court's systematic interpretation of the law can reduce simplicity. For example, to the extent courts refrain from filling in gaps in the tax law and instead take a literalistic approach, i.e., interpret the law based solely on the language of the statute or regulations, courts promote additional detail in legislation by encouraging legislators and the authors of regulations to provide for every contingency in drafting.

[260] In other instances, courts interpret statutory language in a manner that will reach an equitable result for taxpayers, which can lead to inconsistent results among courts. For example, different courts have reached different results with respect to the proper treatment of attorneys' fees in cases such as employment discrimination. ⁵³ Because such fees normally would be treated as a miscellaneous itemized deduction that are (1) not allowed for alternative minimum tax purposes and (2) subject to the two-percent floor on miscellaneous itemized deductions for regular tax purposes, some courts have held that the portion of a damage award payable as attorneys' fees is not required to be included in income. Other courts require the full amount of a damage award to be included in income. Such inconsistent judicial interpretations contribute to complexity and may signal that a change in the law should be considered.

The budget process

[261] Changes to the budget process since the early 1970s, although having beneficial fiscal effects, have led to increased complexity in the tax legislative process, and consequently, to the tax law. The Congressional Budget Impoundment Control Act of 1974, the Gramm-Rudman-Hollings enforcement mechanisms of the Balanced Budget and Emergency Deficit Control Act of 1985, and the expenditure caps and pay-as-you-go enforcement component (revenue neutrality) of the Budget Enforcement Act of 1990 have all led to complexity.

[262] "Budget reconciliation" under the 1974 Act has changed the tax legislative process by requiring that policy measures conform to a Congressional reconciliation resolution that specifies tax and/or spending levels for the budget. Reconciliation also has sped up the process. Reconciliation yields instructions to the tax-writing committees to increase or decrease revenue, and policy must conform to such instructions. In contrast with the pre-reconciliation era, different substantive tax bills often proceed simultaneously in the House and Senate with less time for hearings and amendments. Commentators suggest that substantive tax reform is more difficult because the rationale for tax legislation is to meet the reconciliation instructions and there is less priority on or time for considerations of whether new revenue measures are too complex or sensible. ⁵⁴ The "revenue-driven" approach to tax legislation has been credited with constant churning of the Code, lengthy technical corrections bills, increased regulations projects backlogs, and larger administrative and compliance costs. ⁵⁵

[263] The Gramm-Rudman-Hollings enforcement mechanisms were enacted during a time of large budget deficits. The mechanisms were intended to reduce deficits by a specified amount each year, which meant that changes to tax law could not be made without considering their budgetary impact. As a result, a tax proposal that would lose revenue would be accompanied by a proposal that would recover the lost revenue.

[264] This principle of revenue neutrality undergirded the Revenue Act of 1986, and was formally adopted in the pay-as-you-go provisions of the Budget Enforcement Act of 1990. Although revenue neutrality has some beneficial effects (fiscal discipline), commentators note that it has made it more difficult to enact economically sound revenue losing proposals, proposals that are intended to correct defects in the law, and has made it harder to change proposals that are part of a revenue balance in response to public comment or policy insight. ⁵⁶

[265] Types of complexities resulting from the budget process include the enactment of temporary provisions, delayed effective dates, phasing in of provisions, restrictions on the availability of certain provisions to produce a desired revenue effect, and the design of entire provisions in order to produce a desired revenue target. For example, the income limits at which certain tax benefits (e.g. a credit) are phased out may be chosen based on revenue, rather than on a policy decision as to what the appropriate level should be.

C. USE OF THE FEDERAL TAX SYSTEM TO ADVANCE SOCIAL AND ECONOMIC POLICIES

Growth of tax expenditures

Government spending through tax expenditures

[266] The Code has long been a vehicle for the pursuit of social and economic goals that are not directly related to the policy of simply measuring the income tax base. The Federal tax laws contain numerous provisions that are intended to encourage or discourage specific behaviors or activities. The fiscal costs attributable to these provisions are commonly referred to as "tax expenditures". Tax expenditures may provide alternatives to direct government outlay programs because they are perceived as avoiding the need to establish new agencies or expand existing agencies. In addition, tax expenditures may be favored over direct outlays because they can create the appearance of tax cuts rather than additional government spending and bureaucracy. However, tax expenditures also have been criticized for their adverse effects on the budget process. ⁵⁷ In addition, tax expenditures have contributed to the overall complexity of the Federal tax laws. ⁵⁸

[267] Certain income tax provisions are referred to as tax expenditures because they may be considered to be economically analogous to direct outlay programs, and the two can generally be considered alternative means of accomplishing similar budget policy objectives. ⁵⁹ Tax expenditures are most similar to direct spending programs that have no spending limits and that are available as entitlements to those who meet the statutory criteria established for the programs. ⁶⁰ If a tax expenditure provision were eliminated, Congress might choose to continue financial assistance through other means rather than terminate all Federal assistance for the beneficiaries of the tax expenditure. If a direct outlay program were to be enacted as a substitute for a tax expenditure, the higher revenues received as a result of eliminating the tax expenditure would not necessarily represent a net budget gain because of the corresponding higher direct outlays. In short, tax expenditures can be viewed as government spending programs that are embedded in the tax laws. ⁶¹

Tax expenditure estimates

[268] The Congressional Budget and Impoundment Control Act of 1974 ("the 1974 Budget Act") requires a list of tax expenditures to be included in the annual Federal budget. Congress enacted this requirement with the intent of controlling spending by making tax expenditures more transparent. ⁶² Accordingly, the Treasury and Joint Committee staffs prepare annual estimates of tax expenditures for use in budget analysis. The estimates are a measure of the economic benefits (in terms of reduced tax liabilities) that are provided through the tax laws to various groups of taxpayers and sectors of the economy. ⁶³ They also may be useful in determining the relative merits of achieving specified public goals through tax benefits or direct outlays. ⁶⁴ The Joint Committee staff currently categorizes both individual and business income tax expenditures into the following functional categories: national defense; international affairs; general science, space, and technology; energy; natural resources and environment; agriculture; commerce and housing; transportation; community and regional development; education, training, employment, and social services; health; Medicare; income security; social security and railroad retirement; veterans' benefits and services; general purpose fiscal assistance; and interest. ⁶⁵

Tax expenditures as a source of complexity

[269] The subjectivity that is inherent in the definition of a tax expenditure has often drawn criticism. ⁶⁶ Moreover, the relative merits of tax expenditures and direct outlays have long been the subject of academic debate. ⁶⁷ In any case, the prevalence of tax expenditures is a source of complexity in terms of both scope and number. Following enactment of the 1974 Budget Act, the total number of individual and corporate tax expenditures more than tripled from 43 in 1975 to 133 in 1986. ⁶⁸ Even after the Tax Reform Act of 1986, the total number of individual and corporate tax expenditures was 128 in 1987. ⁶⁹ This number has since grown to 141 under present law. ⁷⁰

Limitations on availability of tax expenditures

[270] Limitations on tax expenditures complicate the Code in several ways. ⁷¹ First, each tax expenditure item generally has its own set of requirements and restrictions that involve additional calculations. In determining the amount of any tax benefit to which a taxpayer is entitled, the basic benefit must be calculated, and then additional computations may be required to apply limitations on the benefit. Separate forms and schedules often are required. Second, many of the techniques used to limit tax expenditures are not commonly used tax principles, or may run counter to general measurement of income concepts, and consequently may raise new interpretive problems. Third, tax expenditure limitations generally impose additional recordkeeping requirements in order to enable the taxpayer to demonstrate that the tax benefit was properly claimed.

[271] Limitations on tax expenditures are often the result of several different, and sometimes conflicting, policy objectives. The terms of any tax expenditure item may reflect a blending of different policies, which typically adds to complexity. Tax expenditure provisions that do not clearly reflect a single policy objective may be more difficult for taxpayers to understand because the purpose of the technical rules may be unclear. In some cases, limitations on the availability of certain tax expenditures may lead to new tax expenditures with a similar purpose targeted at a slightly different group of taxpayers or activity. Such overlapping tax expenditures also result in complexity.

[272] An example of the complexity of limitations on tax expenditures is the earned income credit, which is often cited as one of the most complex provisions of the Code. One objective of the credit is to provide an incentive to work; thus, the amount of the credit generally increases as the amount of the individual's earned income increases. On the other hand, because the credit is targeted to low-income individuals, the credit also begins to phase-out after earned income (or, if greater, modified adjusted gross income) exceeds certain levels. Further, due to concerns that individuals with high net worth but low earned income were receiving the credit, the credit is denied to otherwise eligible individuals that have excessive "disqualified income," meaning income from certain sources, including certain interest, dividends, rents, royalties, and capital gains. Although there are many other features to the earned income credit, these provisions alone create complexity.

[273] Earned income is not otherwise calculated for income tax purposes. Thus, this amount must be determined solely for purposes of the earned income credit. In addition, earned income for purposes of the credit currently includes items that are not includible in gross income, creating the need for information not shown on the return. To determine the correct amount of the earned income credit, a taxpayer must calculate both earned income and modified adjusted gross income. Modified adjusted gross income is uniquely defined for purposes of the earned income credit, and requires calculations and adjustments not required for other purposes. Disqualified income is also a term uniquely defined for purposes of the earned income credit and requires additional calculations.

[274] The present-law education tax incentives are another example of complexity resulting from limitations on tax expenditures. Present law contains at least nine separate tax provisions providing special tax treatment for educational expenses. Each of these provisions has their own eligibility requirements and limitations. Although designed to assist individuals in paying for education, they also complicate the tax planning that is necessary to take advantage of the provisions. ⁷²

[275] The income-based phase-outs applicable to various tax expenditure items are frequently cited as a source of complexity. These phase-outs require additional calculations and also result in hidden marginal rates. ⁷³

[276] Another example is the present-law credit for the cost of rental housing occupied by tenants with incomes below specified levels (the low-income housing credit). The credit generally is allowed over a 10-year period. However, numerous restrictions apply to the credit. The availability of the credit is allocated on a State-by-State basis -- the aggregate credit authority provided annually to each State generally is $1.50 per resident in 2001, increasing to $1.75 per resident in 2002, with an inflation adjustment starting in 2003. However, a minimum annual cap of $2 million is provided for small States in 2001 and 2002, adjusted for inflation starting in 2003. Furthermore, the credit is available at different percentages depending upon (among other things) whether the rent is Federally subsidized.

[277] These are only some of the examples of the difficulties created by limitations on tax expenditures. Although such limitations serve various policy objectives, they also add complexity to the Code.

D. INCREASED COMPLEXITY IN THE ECONOMY

[278] As with any tax structure that plays a central role in raising revenues, the Federal income tax system is complex because of the need to prevent revenue "leakage" by adopting rules that precisely measure the income tax base. Along with these revenue demands, the tendency toward complex income tax rules also is fueled by the importance that has been placed upon equitable treatment of taxpayers. ⁷⁴ In fulfilling these mandates, the Federal income tax system reflects the increasingly dynamic and sophisticated national economy. ⁷⁵ Moreover, income-producing activities are becoming less suited to traditional income realization principles, as the industrial economy in which the Federal income tax has developed gives way to an information and technology economy.

[279] The history of the Federal income tax is characterized by a focus on manufacturing and wage income. Tax issues continue to emerge from these segments of the income tax base, but they typically involve interpretations of long-standing tax rules. On the other hand, more challenging tax issues have been surfacing with increasing frequency from the service sector of the economy. This segment of the income tax base tends to be highly complex and global, particularly with respect to information technology and financial services. The Federal income tax system generally has addressed this portion of the income tax base in a decidedly incremental fashion using the same foundation of income realization principles that better reflects the manufacturing economy. Economic activities such as information technology and financial services are highly mobile and intangible in nature, which presents serious problems for existing tax rules. In this context, the present-law rules that govern areas of taxation such as sourcing and tax accounting are often inapposite or, if applied literally, provide irrational answers.

[280] With the Federal income tax system as the principal source of Federal revenues and equitable tax treatment as a policy priority, the compelling need to accurately gauge an income tax base that itself is complex is likely to continue the bias toward greater overall complexity in the Federal income tax rules, regardless of whether emerging tax issues in the service sector of the economy are addressed incrementally or comprehensively. ⁷⁶ However, undue complexity can be avoided by policy decisions that balance the marginal precision of income tax rules with their marginal complexity. ⁷⁷ The recommendations that are provided in this study pertain to specific instances in which this balance perhaps has not been achieved.

E. INTERACTION OF FEDERAL TAX LAWS WITH STATE LAWS

[281] The application of Federal tax rules often depends upon concepts and principles of State law. Interaction between Federal tax laws and State laws can bring about complexity because taxpayers often must interpret and apply State law in order to determine the correct application of Federal tax law. In many cases, taxpayers must apply laws of multiple States or resolve the application of conflicting laws between States. Even where there is no uncertainty concerning which State's laws apply, the weight accorded to State laws for Federal tax purposes often is unclear. However, the effect of State laws upon the operation of Federal tax rules may be unavoidable in certain situations. Therefore, determining the appropriate degree of interaction between Federal tax laws and State laws is central to simplifying the Federal tax rules and fostering equal tax treatment for taxpayers in different States.

1. State laws generally

[282] A major source of complexity in the Federal tax rules has been the inability to develop a consistent set of basic principles for determining the role of State law in the Federal tax rules. The Federal tax treatment of interests or rights generally is determined by the Federal tax rules. ⁷⁸ However, such interests or rights often are created or defined by State law, and fundamental questions underlying the application of the Federal tax rules often are resolved on the basis of concepts that are constructs of State law.

[283] It has often been difficult to balance the competing objectives of treating taxpayers equitably (which tends to favor giving tax effect to State laws) and simplifying the Federal tax rules (which tends to favor curtailing the relevance of State law). ⁷⁹ Moreover, the Federal courts have not always agreed on the appropriate balance. For instance, the Federal circuit courts currently disagree over the question of whether State law alone determines the deductibility of estate administration expenses under section 2053. ⁸⁰ Similarly, the Supreme Court recently resolved a split among the Federal circuit courts when it held that a disclaimer of inheritance property under State law could not prevent a Federal tax lien from attaching to the property. ⁸¹

[284] The problem is compounded in cases involving an interpretation of a State law that has not been conclusively resolved by the State itself. In Commissioner v. Estate of Bosch,/82/ the Supreme Court attempted to articulate an analytical rule for resolving Federal tax issues when the application of the Federal tax rules depends upon State law interests or rights that have been adjudicated in State court by the taxpayer. In Bosch, the Court held that Federal courts should follow the decisions of a State's highest court, but that decisions of lower State courts are entitled only to "proper regard". ⁸³ Absent an interpretation of State law by the highest court in the State, the Court stated that Federal courts would be, "in effect, sitting as a state court."/84/

[285] The exact meaning and scope of the Bosch standard has been the subject of extensive academic commentary. ⁸⁵ In addition, Federal courts have encountered difficulty with Bosch and, as a result, have been inconsistent in the level of deference given to decisions of lower State courts. ⁸⁶ As a result, the Bosch decision has lead to complexity and uncertainty with regard to particular Federal tax rules that rely heavily upon State law. ⁸⁷ Without further elaboration by the Supreme Court clarifying Bosch,/88/ it will continue to be difficult to achieve equitable and consistent treatment of taxpayers in different States by incorporating State law into the Federal tax rules. The perils (to taxpayers and the government alike) of determining the treatment of taxpayers in different States under the Bosch standard strengthen the relative advantages of rules that avoid complexity by curtailing the role of State law in the application of the Federal tax laws.

2. State property rights laws

State community property laws

[286] State community property laws have had an impact upon the complexity of Federal tax rules for many years, particularly with regard to estate and gift taxes and tax return filing status. ⁸⁹

Estate and gift taxes

[287] In 1942, Congress first made changes to the estate and gift tax rules in an attempt to equate the treatment of property in community property States and non-community property States by providing that, in both community property States and non-community property States, each spouse would be taxed on the portion of jointly-owned or community property that each spouse contributed to that property's acquisition cost. ⁹⁰

[288] However, this solution to the community property problem was viewed as complex and, in 1948, Congress created a different solution for equating the estate and gift tax treatment of taxpayers in community property States and in non-community property States. Specifically, Congress provided the decedent or donor spouse with a marital deduction for 50 percent of the property transferred to the other spouse, effectively allowing both spouses to be taxed on one- half of the property's value. ⁹¹

[289] In the Economic Recovery Act of 1981,/92/ Congress neutralized the general effect of State community property laws on estate and gift taxes by creating an unlimited deduction for transfers to spouses. ⁹³ Nevertheless, a number of estate and gift tax rules continue to provide specific rules addressing the effect of State community property laws. ⁹⁴

Tax return filing status

[290] Prior to 1948, most married taxpayers derived no tax benefit from filing a joint return because there was only one income tax schedule and all individuals were liable for income tax as separate filing units. ⁹⁵ Progressive tax rates created an incentive for married couples to split incomes. If only one spouse earned income, the couple could reduce their combined tax liability by splitting the income and assigning half to each spouse. Although the Supreme Court rejected contractual attempts to split income,/96/ it ruled that income splitting was actually required for community income in States with community property laws. ⁹⁷ Thus, married couples in community property States exclusively enjoyed the benefits of income splitting, regardless of whether they filed a joint return. By contrast, married couples in separate property States were precluded from receiving the benefits of income splitting, regardless of whether they filed a joint return. With the increase of both income tax rates and the number of individuals liable for income taxes in the years immediately before and during World War II, many States adopted or considered community property statutes to provide their citizens the tax benefits of income splitting.

[291] The Revenue Act of 1948 extended the benefit of income splitting to all married couples by establishing a separate tax schedule for joint returns. The separate schedule was designed. so that married couples would pay twice the tax of a single taxpayer with half the couple's taxable income. The new schedule succeeded in equalizing the treatment between married couples in States with community property laws and those in States with separate property laws. However, it also introduced a "marriage bonus" for couples in States with separate property laws. ⁹⁸ A special rate schedule was subsequently created for single taxpayers (leaving the old schedule solely for married individuals filing separate returns), which created a "marriage penalty" for some taxpayers while maintaining the "marriage bonus" for other taxpayers. The result of attempts to neutralize the effect of State community property laws on Federal tax return filing status has been increased complexity, as well as substantive distinctions in tax treatment based upon filing status.

Joint and several liability

[292] State community property laws also have affected the rules concerning the mutual tax liability of married couples. In Poe v. Seaborn,/99/ the Supreme Court held that each spouse in a community property State is liable for the tax on one-half of the other spouse's earned income, even when they file separately. Congress subsequently addressed the issue of joint and several tax liability of spouses living in community property States. Congress was specifically concerned that the Poe rule could result in an estranged spouse being liable for Federal income tax on one-half of the income earned by the other spouse, even though the estranged spouse had not actually received or benefited from any of the income. ¹⁰⁰ Congress changed this result by creating new section 66,/101/ which provided that a spouse would not be liable for Federal income tax on one-half of the income earned by the other spouse in a community property State if (1) the spouses live apart at all times during the calendar year, (2) they do not file a joint return, (3) one or both spouses have income which is community income, and (4) no portion of such earned income is directly or indirectly transferred between such spouses during the calendar year. ¹⁰² Instead, each spouse would be liable for the tax on his or her respective earned income and on community income derived from the separate property (determined under applicable community property laws) of each spouse.

[293] In 1984, Congress significantly broadened the application of the innocent spouse exception to joint and several liability for taxable income reported on joint tax returns. ¹⁰³ Congress also provided similar (but not identical) innocent spouse relief to married couples who lived together and filed separate returns in community property States. ¹⁰⁴ Specifically, Congress amended section 66 to provide that an innocent spouse may not be held liable for tax on community income derived from the separate property of the other spouse if the innocent spouse proves that he or she did not know of, and had no reason to know of, the omitted income and that it would be inequitable to hold the innocent spouse liable for such tax. Nevertheless, the Poe rule continues to treat married taxpayers who file separate returns differently on the basis of whether they live in a community property State. While married taxpayers in separate property States can automatically avoid joint and several liability by filing separate returns, married taxpayers in community property States can avoid joint and several liability by filing separate returns only if they satisfy the requirements of section 66. ¹⁰⁵

State law homestead exemptions

[294] Under present law, section 6321 provides for the imposition of a Federal tax lien upon all real and personal property belonging to a taxpayer who fails to pay a Federal tax assessment after notice and demand for payment has been made. In identifying which property or property rights may be subject to a Federal tax lien, State law generally governs whether a taxpayer has a recognized interest in property. ¹⁰⁶ However, State laws that merely protect property from creditors (rather than actually defining interests in property) do not preclude the attachment of a Federal tax lien. For instance, most States have enacted homestead laws that generally permit a debtor to designate his or her principal residence and the associated land as a homestead, thus protecting the property from the general debts of the debtor. Homestead exemptions do not protect property from attachment or execution of a Federal tax lien, even if the tax liability belongs to only one spouse and the homestead exemption belongs to the other spouse. ¹⁰⁷ However, depending upon whether the homestead exemption of a particular State also provides both spouses with a vested lifetime interest in the property, the spouse who does not owe the Federal tax liability may be entitled to share in the proceeds of an administrative or judicial sale of the property pursuant to the tax lien. ¹⁰⁸

[295] The delineation between State law homestead exemptions and State laws that actually define property rights is often unclear and contributes to the complexity of the Federal tax rules. In addition, the reach of a Federal tax lien is often further complicated by the intricate distinctions among various types of State law property interests such as joint tenancy, tenancy in common, tenancy by the entirety, curtesy and dower, and community property. Taxpayers should be able to expect that the operation of Federal tax rules will reasonably reflect their recognized property interests as defined by State law. However, the interaction between State property rights law and the Federal tax rules creates complexity for taxpayers, especially with regard to cases in which subtle distinctions among various State property rights are not particularly relevant to tax policy.

3. State regulatory laws

[296] Taxpayers in regulated industries generally are subject to State regulatory accounting rules that differ from the Federal tax rules, primarily because of differences in purpose and function. In some cases, the divergence of Federal tax rules from State regulatory accounting rules creates additional complexity in reconciling regulatory income with taxable income. In other cases, taxpayers in regulated industries must apply special tax rules that incorporate State regulatory requirements. The interaction of Federal tax laws with State regulatory requirements is often the result of deliberate policy considerations. However, tax rules that draw distinctions among taxpayers based upon their regulated status constitute sources of complexity. Complexity based upon regulatory status may not be warranted for certain industries in which the regulatory environment that originally justified such complexity has evolved in fundamental ways.

Public utilities

[297] Public utilities are subject to several special provisions that contribute to the complexity of the Federal tax rules, particularly because they assume a regulatory framework that is currently undergoing fundamental restructuring as a result of deregulation in the electricity industry. ¹⁰⁹ In addition, Federal tax rules of general application often create complexity for public utilities because they may not adequately take into account unique characteristics of public utilities or certain issues raised by deregulation.

[298] For instance, in order for certain public utility property to be eligible for the more favorable depreciation allowances available under present law (relative to the depreciation allowances used for ratemaking or financial statement purposes), the tax benefits of accelerated depreciation must be "normalized" in setting rates charged by utilities to customers and in reflecting operating results in regulated books of account. ¹¹⁰ Normalization accounting is generally intended to prevent regulated public utilities from passing the tax benefits of accelerated depreciation to customers through the ratemaking process. The normalization method of accounting generally spreads the tax benefits of accelerated depreciation over the regulatory life of the property and results in higher utility rates in the early years and lower utility rates in the later years than otherwise would have occurred without normalization. In addition to being inherently complex, normalization accounting raises certain issues associated with the ongoing restructuring of certain public utilities. If a public utility is deregulated with respect to only a portion of its services (e.g., electricity generation and transmission services but not distribution services), then a portion of the utility's property will remain subject to the normalization requirements, while the remainder of the utility's will not. The determination of whether certain property is subject to normalization accounting under this scenario may be difficult.

[299] More generally, the complexity that accompanies the tax treatment of public utilities is compounded by deregulation of the electricity industry. The Financial Freedom Act of 1999 (H.R. 2488) passed by Congress (but vetoed by the President) included a provision that would have amended the tax rules relating to the deductibility of nuclear power plant decommissioning costs. Observing that electricity deregulation has created the need for changes to present law, Congress viewed this provision as an appropriate interim measure until more fundamental changes could be made at the appropriate time. ¹¹¹

Insurance companies

[300] The interaction between Federal tax laws and State regulatory laws is also evident in the tax rules that apply to life insurance companies. Although tax accounting rules generally operate independently from financial or regulatory accounting rules, the tax rules for life insurance companies are noteworthy in being derived, in part, from regulatory accounting principles. ¹¹² In determining the taxable income of a life insurance company, the computation of certain reserve items under section 807 refers to various State insurance regulatory rules relating to reserve computation methods, discount rates, and standard mortality and morbidity tables for determining unpaid losses (secs. 807(d), 816(b)). ¹¹³ The adjustments that are required in order to compute taxable income from State regulatory income constitute a source of complexity.

[301] Opposing policy goals of the Federal income tax laws and the State insurance regulatory rules may lead to a divergence in results under the two systems.

4. State laws concerning entity classification

[302] The classification of a non-corporate entity as a partnership or corporation for Federal tax purposes has become largely elective. ¹¹⁴ The entity classification rules generally permit non-corporate entities with a single owner to be disregarded for Federal income tax purposes. ¹¹⁵ As compared to the entity classification tax rules that were in effect prior to 1996, the present-law rules are less reliant upon State law concepts. However, there continues to be some interaction between the present-law rules and various State laws. ¹¹⁶

[303] The advent of disregarded entities has raised issues under State law that could necessitate additional complexity in future administrative guidance. In fact, certain interpretive problems have already begun to emerge in the application of State law to entities that are disregarded under the Federal entity classification rules. For instance, present law generally provides nonrecognition treatment of gain or loss associated with a corporate reorganization. Section 368(a)(1)(A) defines corporate reorganizations to include statutory mergers or consolidations. Current regulations require a statutory merger or consolidation under section 368(a)(1)(A) to be effected pursuant to the corporation laws of the United States or a State or territory, or the District of Columbia. ¹¹⁷ Last year, the Treasury Department published proposed regulations that would exclude from the definition of a statutory merger or consolidation any merger involving a disregarded entity, even if the disregarded entity is recognized under State law as a separate entity and the merger meets the requirements of State law. ¹¹⁸ As taxpayers gain further experience with the Federal entity classification rules, it is likely that the coordination between the entity classification rules and State law will continue to be a source of complexity.

5. State income tax laws

[304] Most States that impose an income tax generally conform their tax base to the Federal income tax base. However, the degree of conformity varies widely among the States, creating complexity for taxpayers who are subject to both Federal and State income taxes. This complexity is compounded for taxpayers who are subject to income taxes in multiple States. While the income tax base of a few States is in full conformity with the Federal income tax base,/119/ the remaining States determine their income tax base by making various additive and subtractive adjustments to Federal adjusted gross income. ¹²⁰

[305] The interaction between Federal and State income tax laws as a source of complexity may be an unavoidable product of the desire of States to preserve autonomy over their own tax laws. ¹²¹ Nevertheless, the frequency and extent of changes to the Federal income tax laws can have the effect of exacerbating the complexity of State income tax laws, particularly in States that only conform to Federal tax laws in effect on a particular date rather than on a continuing basis that takes into account subsequent changes to the Federal tax rules. ¹²² Congress has made at least one attempt to eliminate the complexity arising from the interaction of Federal and State tax laws. In 1972, the Federal-State Tax Collection Act ("1972 Act") was enacted to encourage States to conform their income tax base to the Federal income tax base. ¹²³ The 1972 Act offered States the opportunity to enter into an agreement to have the Federal government collect and administer their individual income taxes. ¹²⁴ In return, States entering into such an agreement would be required to fully conform their individual income tax base to the Federal income tax base (subject to certain specified adjustments). However, the provisions of the 1972 Act were repealed in 1990 after no State had entered into an agreement. ¹²⁵ The demise of the 1972 Act illustrates the inherent difficulties in addressing (at least on the Federal level) the complexity that arises from the interaction between the Federal and State tax rules.

F. INTERACTION OF FEDERAL TAX LAWS WITH OTHER FEDERAL LAWS AND STANDARDS

1. Federal securities laws

[306] Under present law, at least 24 sections of the Internal Revenue Code contain direct references to Federal securities laws such as the Securities Act of 1933, Securities Exchange Act of 1934, Commodity Exchange Act, and Investment Company Act of 1940. ¹²⁶ Generally, these references are definitional in nature and provide a measure of uniformity and consistency for both tax and non-tax purposes. ¹²⁷ Substantive interaction between the Federal tax and securities laws often occurs when the tax rules are amended in response to securities law developments. If the structural tax rules are preserved, these legislative and administrative attempts to address the tax implications of securities law changes can contribute to complexity. ¹²⁸ In some cases, the complexity of specific tax rules has been moderated by simply referring to existing securities laws. ¹²⁹

[307] Occasionally, the interaction between the Federal tax laws and securities laws is moire implicit, particularly with regard to disclosure. For instance, the original issue discount regulations governing certain contingent payment debt instruments require interest expense and income accruals based in part upon a projected payment schedule provided by the issuer. ¹³⁰ This requirement has raised the concern that a projected payment schedule could be construed as a forward-looking statement with implications for exposing the issuer to liability under securities laws. ¹³¹ Section 1272(a)(6) contains a similar requirement for determining original issue discount accruals on certain debt instruments that are subject to prepayment. ¹³² The complexity arising from securities law disclosure issues would become more pronounced if such accrual-based rules were extended beyond the context of original issue discount.

2. Federal labor laws

[308] Present law sections 401 through 420 provide detailed rules for determining whether certain employee retirement benefit plans and individual retirement plans qualify for preferential tax status. ¹³³ These rules were significantly revised and coordinated with Federal labor laws concerning employee benefit plans as part of the Employee Retirement Income Security Act of 1974 ("ERISA"). The enforcement of ERISA laws by the Department of Labor does not affect whether a plan qualifies for preferential tax status. For instance, certain plans that are not intended to qualify for preferential tax status are nevertheless subject to ERISA requirements, while other plans that are exempt from ERISA requirements can still qualify for preferential tax status if they meet the conditions of the applicable tax rules. ¹³⁴ However, there is significant overlap between the ERISA rules and the tax rules,/135/ with at least 34 sections of the Internal Revenue Code containing direct references to ERISA provisions. ¹³⁶ In fact, Treasury and the IRS share joint responsibility with the Department of Labor for the administration of the ERISA laws. ¹³⁷

[309] The Federal tax rules concerning employee benefit plans are complex, and the interaction of these rules with the ERISA laws heightens the risk that the failure of an employee benefit plan to qualify for tax benefits will also create exposure to civil enforcement action under ERISA. However, the coordination of the tax rules with ERISA requirements ensures the application of consistent standards in common areas of concern shared by the tax laws and the labor laws. ¹³⁸

3. Generally accepted accounting principles

[310] Section 446(a) provides a general book conformity rule that requires taxpayers to compute taxable income in a manner that is consistent with the taxpayer's method of computing income in keeping his books. This provision recognizes that no uniform method of accounting can be prescribed for all taxpayers and that a taxpayer shall adopt a method that is best suited to its needs. However, a method of accounting that does not clearly reflect income is not permitted. In general, a method of accounting that conforms to generally accepted accounting principles in a particular trade or business will be regarded as clearly reflecting income as long as it is consistently applied.

[311] Although taxpayers are generally permitted to compute taxable income in a manner that is consistent with the overall method of keeping their books, the tax treatment of many items is governed by specific tax provisions without regard to the financial accounting treatment of the item by the taxpayer. In fact, the "conformity" of taxable income to financial accounting income has gradually eroded over time with the enactment of specific tax provisions that govern the treatment of items in a manner that varies from what is permitted or required for financial accounting purposes. ¹³⁹ Computing the numerous adjustments that are required in order to derive taxable income from financial income is a source of complexity in the Federal tax rules, as well as a primary cause of disputes between the IRS and business taxpayers. Nevertheless, this complexity has often been justified by the distinctions between the policies and objectives of the Federal tax rules as compared to those of financial accounting standards. These policy differences and the discretion that is often permitted by generally accepted accounting principle rules are factors that many have cited as preventing broad-based conformity between the Federal tax rules and financial accounting standards. ¹⁴⁰ Although broad-based conformity may not be desirable or feasible, the additional complexity that is caused by the particular differences between tax accounting and financial accounting should be weighed against the policy reasons for such differences. ¹⁴¹

G. INTERACTION OF FEDERAL TAX LAWS WITH LAWS OF FOREIGN COUNTRIES AND TAX TREATIES

1. Laws of foreign countries

Overview of interaction between United States tax laws and foreign laws

[312] The United States taxes the income of U.S. citizens, residents, and corporations (collectively, "U.S. persons") on a worldwide basis, regardless of whether the income is derived from sources within the United States or elsewhere. In addition, the United States taxes nonresident foreign individuals and foreign corporations (collectively, "foreign persons") on income that has a sufficient nexus to the United States.

[313] For U.S. persons with relationships or activities in foreign countries, the intrinsic complexity of the U.S. tax rules often is compounded by the interaction of these rules with the laws of foreign countries, particularly for taxpayers who are subject to foreign taxes. ¹⁴² From a transactional perspective, the interplay between U.S. tax laws and the laws of foreign countries can be remarkably complex when applied to cross-border transactions. This complexity is attributable to several factors, including (1) the effect that foreign law can have on determining the U.S. tax consequences of a cross-border transaction, and (2) the fact that U.S. and foreign laws independently may give rise to tax consequences with respect to the same cross-border transaction. Because two or more different tax jurisdictions will be involved, the income from cross-border transactions and activities is likely to face a significantly more complicated tax environment than income from transactions and activities located solely within the United States. ¹⁴³ Therefore, taxpayers must consider the rules under which income is taxed in both (or all) jurisdictions. In the case of a country with which the United States has a tax treaty in effect, the taxpayer also must consider any special treaty rules that pertain to the transaction, in addition to the general rules of the two (or more) tax jurisdictions.

Explicit interaction between United States tax laws and foreign laws

[314] Several U.S. tax law provisions explicitly address the impact of foreign law on the determination of U.S. tax liabilities. ¹⁴⁴ For instance, the U.S. tax rules that provide credits for foreign taxes paid ("foreign tax credits") contain many definitional requirements relating to foreign law that are relevant in determining whether a taxpayer has paid a creditable foreign tax. In particular, the foreign tax credit regulations provide that a foreign tax is creditable only if the tax "requires a compulsory payment pursuant to the authority of a foreign country to levy taxes."/145/ The regulations further provide that "[w]hether a foreign levy requires a compulsory payment pursuant to a foreign country's authority to levy taxes is determined by principles of U.S. law and not by principles of law of the foreign country. ¹⁴⁶

[315] Courts are often called upon to adjudicate issues in which the application of U.S. tax laws explicitly hinges upon an examination of foreign law. ¹⁴⁷ For example, a recent case under section 901 involved the issue of whether "net loans" made by a U.S. bank to the Brazilian Central Bank gave rise to foreign tax credits because of Brazilian taxes that were withheld from the interest payments and paid by the Brazilian Central Bank on behalf of the U.S. bank. ¹⁴⁸ The IRS contended that the Brazilian taxes did not qualify for the foreign tax credit because they were not "compulsory" but, rather, were voluntary. ¹⁴⁹ Reversing a Tax Court decision in favor of the IRS, the D.C. Circuit Court of Appeals held that the taxes withheld and paid by the Brazilian Central Bank were "compulsory" and, thus, potentially creditable. ¹⁵⁰ This case illustrates the practical difficulties faced by taxpayers and the IRS in properly discerning the interaction between foreign law and U.S. tax rules when the permissible relevance of foreign law is limited in scope but the applicable U.S. tax rules are fundamentally a function of foreign law. ¹⁵¹

Implicit interaction between United States tax laws and foreign tax laws

[316] U.S. and foreign tax laws also can implicitly interact by independently giving rise to tax consequences under each country's laws with respect to the same transaction. For example, a sale by a U.S. corporation to a foreign customer through its foreign branch is taxable to the U.S. corporation by the United States. Assuming that the U.S. corporation maintains a taxable presence in the foreign jurisdiction, the sale will also be taxable by the foreign jurisdiction. Consequently, the interaction of U.S. tax rules with the tax laws of other countries creates complexity, in terms of the need to consider the laws of each country, and can result in certain adverse consequences, such as the potential for double taxation. ¹⁵² Some of these consequences can be addressed by general provisions in the laws of one or both countries (e.g., foreign tax credits or exemptions from tax), or through special rules contained in a treaty that govern the primary or exclusive jurisdictional tax rights of each country.

[317] The complexity that arises from the implicit interaction between foreign laws and the U.S. tax rules can lead to tax arbitrage opportunities for taxpayers, particularly when the foreign laws and the U.S. tax rules yield inconsistent tax results for the same transaction. For instance, the implicit interaction between foreign laws and the U.S. tax rules can give rise to multiple depreciation deductions in a cross-border leasing transaction in which the taxpayer retains legal title to leased property in a country that provides depreciation deductions based upon legal (rather than economic) ownership of property, and transfers economic ownership of the property to another party in a different country in which depreciation deductions are based upon economic (rather than legal) ownership. ¹⁵³

[318] The inherent complexity of the interaction between U.S. and foreign tax laws can be compounded if the United States and the foreign country have entered into a tax treaty containing special provisions that must be considered in addition to the general provisions of U.S. and foreign laws, as described below.

2. Tax treaties

Overview of tax treaties

[319] The traditional objective of U.S. tax treaties has been to preclude international double taxation and prevent tax avoidance and evasion. Another related objective of U.S. tax treaties is the removal of barriers to trade, capital flows, and commercial travel that may otherwise be caused by overlapping tax jurisdictions. U.S. tax treaties also reduce the burdens of complying with the tax laws of a jurisdiction merely because the taxpayer has minimal contacts with and derives minimal income from the jurisdiction.

[320] Tax treaties generally prevent double taxation by requiring each country to limit, in specified situations, its right to tax income earned in its territory by residents of the other country. Thus, tax that otherwise would be imposed under applicable foreign tax laws on certain foreign-source income earned by U.S. persons may be reduced or eliminated by treaty. Conversely, U.S. tax on U.S.-source income earned by foreign persons may be reduced or eliminated by treaty provisions that treat certain foreign taxes as creditable for purposes of computing U.S. tax liability.

[321] For the most part, the various rate reductions and exemptions agreed to by the source country in treaties are premised on the assumption that the country of residence will tax the income at levels comparable to those imposed by the source country on its residents. Treaties also eliminate double taxation by requiring the country of residence to provide a credit for any taxes that the source country imposes under the treaty. For certain types of income, tax treaties may require the country of residence to exempt income that is taxed by the source country.

[322] Tax treaties generally preclude tax avoidance and evasion by providing for the exchange of tax-related information between the tax authorities of the contracting countries when such information is necessary for carrying out provisions of the treaty or of their domestic laws.

Interaction between tax treaties and United States tax laws

[323] To a large extent, tax treaty provisions that are designed to prevent international double taxation, and to preclude tax avoidance and evasion, supplement certain U.S. tax law provisions that have the same objectives. ¹⁵⁴ Treaty provisions modify the generally applicable U.S. statutory rules in order to take into account the particular tax system of the treaty partner.

[324] Section 894(a) generally provides that the U.S. tax laws are to be applied "with due regard to any treaty obligation of the United States." The language of section 894(a) indicates a relationship between tax treaties and the U.S. tax laws in which the priority of one over the other generally relies upon rules of statutory interpretation. ¹⁵⁵ However, certain provisions of the Code explicitly address the interaction between U.S. tax laws and tax treaties when they might otherwise conflict. ¹⁵⁶ When Congress has not specifically provided for priority between a tax law and tax treaty, courts generally have attempted to supply a harmonious interpretation of the law and treaty. When such interpretation is not possible, courts generally have given priority to the rules that came into effect later in time. ¹⁵⁷

[325] In 1988, the "later-in-time" principle was effectively codified in section 7852(d)(1), which provides that, "[f]or purposes of determining the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law."/158/ Section 7852(d)(1) is the operative statutory rule for resolving potential future conflicts between U.S. tax laws and tax treaties. ¹⁵⁹ Although the "later-in-time" rule can result in treaty overrides in certain circumstances, it can be viewed as an easily administrable rule of general application for addressing some of the complexities associated with the interaction and conflicts between U.S. tax laws and tax treaties.

[326] The interaction of tax treaty provisions with U.S. tax laws -- as well as the tax laws of the treaty partner -- can introduce complexity for taxpayers and tax administrators. In many cases, a single taxpayer may be subject to multiple tax regimes on otherwise similar transactions because the transactions involve different taxing jurisdictions with different treaties. While some complexity must necessarily result from different countries choosing different tax policies, tax treaty provisions should complement U.S. tax law provisions whenever possible. Therefore, ensuring consistency between tax treaty provisions and U.S. tax laws can reduce the complexity and compliance burdens that are often associated with international transactions and activities of taxpayers.

III. EFFECTS OF COMPLEXITY ON THE PRESENT-LAW FEDERAL TAX SYSTEM

A. OVERVIEW

[327] There are a number of ways in which complexity can affect the Federal tax system. Among the more commonly recognized effects are: (1) decreased levels of voluntary compliance; (2) increased costs of compliance for taxpayers; (3) reduced perceptions of fairness in the Federal tax system; and (4) increased difficulties in the administration of tax laws. ¹⁶⁰ Although there is general agreement among experts that complexity has these adverse effects, there is no consensus on the most appropriate method of measuring the effects of complexity. Consequently, the staff of the Joint Committee on Taxation has not attempted to quantify the precise effects of complexity on the tax system; the staff has, however, described qualitatively these commonly recognized effects and presented information to assist in analyzing these effects.

[328] There are different types of complexity, which can have differing effects. Complexity may in some instances lead to uncertainty in the correct application of the law to particular facts. One example of this is the rules relating to whether certain expenses must be capitalized. In other instances, complexity may involve numerous and tedious computations, with little attendant uncertainty other than computational accuracy. One example of this is the computation of the special rates of tax applicable to capital gains.

[329] Another important factor in analyzing the effects of complexity on the Federal tax system is whether the tax complexity is a function of the complexity of the underlying transactions into which the taxpayer has chosen to enter, as opposed to tax complexity that is generally unrelated to transactional complexity. An example of the former is the taxation of derivatives and other financial transactions; an example of the latter are the rules relating to the earned income credit. While both types of complexity deserve consideration, it is conceivable that greater progress in simplification could be made with regard to tax complexity that is unrelated to the complexity of the underlying transactions.

B. DECREASED LEVELS OF VOLUNTARY COMPLIANCE

[330] It is theoretically possible to measure changes in the level of voluntary compliance over time and correlate those changes to changes in the level of complexity in the Federal tax system that occur during the same period. However, it is not possible to do so as a practical matter, for several reasons. First, there has not been consistent measurement of the levels of voluntary compliance in over a decade. For several years, the IRS conducted comprehensive Taxpayer Compliance Measurement Program surveys, which generally consisted of intensive audits of statistically valid samples of taxpayers. However, the last survey was conducted in 1988, and more recent data on taxpayer compliance that can be correlated with the earlier Taxpayer Compliance Measurement Program data is unavailable. Second, there is no generally agreed upon measure of changes in the level of complexity in the Federal tax system over time. Third, it is not clear the extent to which factors other than changes in the level of complexity in the Federal tax system (such as economic factors) may also influence changes in the levels of voluntary compliance.

[331] Complexity can create taxpayer confusion,/161/ which may affect the levels of voluntary compliance through either inadvertent errors or intentional behavior by taxpayers. The effect of this uncertainty on the level of voluntary compliance is not necessarily downward. For example, an individual taxpayer preparing his own tax return may, when faced with a complex area of the Code where there are no clear answers, choose to take a conservative filing position (perhaps out of a desire to avoid controversy with the IRS).

[332] Complexity that creates uncertainty also can affect the levels of voluntary compliance through intentional behavior by taxpayers. This will likely have a downward effect on tax compliance because complexity can foster multiple interpretations of the law and aggressive planning opportunities. In addition, taxpayers may consciously decide to "play the audit lottery" by taking a questionable position on their tax returns, in the belief that complexity will at best shield them from discovery and at worst prevent the imposition of penalties.

C. COSTS OF COMPLEXITY

[333] The Joint Committee staff considered whether it is possible to quantify some of the possible costs of complexity for taxpayers. For purposes of this discussion, the expenditure of both time and money are considered costs.

[334] Although there is no single factor by which the costs of complexity can be measured, there are certain indicators of complexity that may be useful to consider. The following discussion considers the following possible indicators of complexity: (1) increased time required by taxpayers to prepare and complete tax returns and increased use of tax return preparers, and (2) increased assistance to taxpayers provided by the IRS.

[335] Commentators often state that complexity of the Federal tax system results in increased costs of compliance for taxpayers. ¹⁶² The Joint Committee staff explored whether it is possible to quantify some of the costs of complexity under present law. The Joint Committee staff found that many of the commonly used measures of the costs of compliance, such as the estimate of time required to prepare tax returns, do not provide reliable indicators of such costs. However, some relevant information can be gleaned from the information available.

Individual return preparation time and use of tax return preparers

IRS estimates of individual return preparation time

[336] As required by the Paperwork Reduction Act of 1980, the IRS provides estimates of the amount of time taxpayers spend to comply with the Federal income tax. To meet this requirement, the IRS contracted with an outside consultant to analyze a sample of 1983 Federal individual income tax returns and estimate the amount of time taxpayers spend in: (1) record keeping activities; (2) learning how to prepare the return; (3) finding and using tax preparation services and preparing the return; and (4) copying and sending in the return. Estimates of these activities are included in the instructions that accompany the various tax forms. ¹⁶³ For example, the IRS estimates that the tax year 2000 Form 1040 will, on average, require taxpayers to spend 2 hours and 45 minutes in record keeping activities, 3 hours and 25 minutes to learn about the law or form, 6 hours and 16 minutes to prepare the form, and 35 minutes to copy, assemble and send the form to the IRS. ¹⁶⁴

Use of tax return preparers

[337] These estimates of the amount of time taxpayers spend on average assume that no assistance is provided to the taxpayer. In fact, many taxpayers use one or more of the following forms of assistance to prepare and file their returns: paid preparers (such as a tax return preparation service, a certified public accountant or an attorney); computer software; tax guides and other publications; electronic filing; filing using a telephone; and filing over the Internet. Each of these forms of tax return filing assistance may reduce the overall time required for the preparation and filing of individual income tax returns. Thus, the IRS estimates of time spent complying with the Federal individual income tax may somewhat overstate the amount of time taxpayers spend on these efforts. To illustrate the growing importance of these alternative forms of tax return preparation assistance and filing, the following table shows the use of various forms of assistance by taxpayers on their 1990 and 1999 Federal income tax returns.

Table 3. -- Individual Income Tax Returns Filed in 1990 and 1999

______________________________________________________________________

[339] Second, there has been a large increase in the percent of individual income tax returns prepared with computer software, from approximately 16 percent of returns filed in 1990 to 46 percent of returns filed in 1999. It is difficult to assess the impact of the increased use of computer software for return filing. The increased use of such software could suggest that taxpayers are purchasing such software because of increased complexity of the present-law Federal tax system. However, it also can be argued that the increase in the number of households with personal computers and the widespread availability of low-cost software reduces the burden of complexity for taxpayers by automating many of the time-consuming calculations that taxpayers previously performed by hand. While the use of computer software may reduce computational burdens for individual taxpayers, it does not eliminate the burdens of keeping records and making certain determinations.

[340] Finally, the last three rows of the table show that there has been a large increase in the use of electronic means of filing income tax returns, from approximately 4 percent of returns filed in 1990 (electronic filing) to approximately 23 percent of returns filed in 1999 (17 percent for electronic filing, 4 percent for tele-file, and 2 percent for filing over the Internet). It is anticipated that the percentage of electronically filed income tax returns will continue to increase dramatically. ¹⁶⁵

[341] As noted above, the current IRS paperwork burden estimates do not reflect the use of paid preparers, computer software, or electronic means of filing tax returns. Further, electronic means of filing tax returns provide several benefits not reflected in the current IRS estimates of the amount of time taxpayers spend complying with the Federal tax law. First, taxpayers may spend less time preparing tax forms and copying, assembling and sending in the returns. Second, taxpayers spend less time learning about the law, or the correct form to use. Third, because computer software is generally more thorough in analyzing taxpayers' situations than taxpayers would be themselves, the number of taxpayer errors may be reduced. For these reasons, the IRS hourly estimates of the amount of time taxpayers spend complying with the Federal individual income tax may be somewhat overstated. The IRS is in the process of updating these estimates with a new study of the amount of time taxpayers spend complying with present law.

[342] However, even assuming the current estimates overstate the amount of time individual taxpayers spend complying with present law, the tax laws nevertheless impose compliance burdens on individual taxpayers. Changes to the law, such as the addition of new targeted tax benefits for individuals, increase these burdens by adding provisions for which taxpayers must (1) assess their eligibility, (2) retain records, and (3) prepare the proper forms or worksheets.

Return preparation time and the cost of compliance

[343] Some analysts have suggested that a measure of the cost to the taxpayer of complying with the Federal income tax could be estimated by applying an estimate of the value of a taxpayer's time to an estimate of the amount of time a taxpayer spends in complying with the Federal individual income tax. To do this requires an estimate of the average value of a taxpayer's time. Some analysts have inferred the value of a taxpayer's time by observing reported amounts of earned income from tax returns. For example, some analysts would use amounts of taxpayer-reported income to infer an hourly wage rate for taxpayers. This methodology has resulted in an estimate of the combined average time and resource cost to individual taxpayers for both Federal and State income taxes of $12.53 per hour for 1982. ¹⁶⁶ In its fiscal year 1998 Budget in Brief, the IRS used an estimate of $20 per hour in 1998, which essentially comports with the 1982 estimate on an inflation-adjusted basis. ¹⁶⁷

[344] Other analysts have inferred the value of a taxpayer's time by observing the market price for professional tax services. For example, this was the approach used by The Tax Foundation in their testimony presented to the House Ways and Means Committee on June 5, 1995. They estimated the average value of a taxpayer's time as an average of the IRS hourly wage rate and that of a tax professional at a large, national accounting firm of $39.60 per hour in 1995. ¹⁶⁸ This last estimate of the value of taxpayer time may be biased upwards because it assumes that the value of time for a tax professional is the average value of time for all individuals who file tax returns. ¹⁶⁹

[345] Deriving an estimate of the average value of taxpayer time is a difficult undertaking because it often involves ascertaining the willingness of taxpayers to pay for services they do not consume. At present, there is no clear consensus among economists as to how these estimates should be made. As part of its ongoing effort to revise estimates of the amount of time taxpayers spend in compliance activities, the IRS also is investigating the appropriate measure of the value of taxpayer time for tax compliance activities.

[346] In summary, popularly reported estimates of taxpayers compliance costs that simply multiply the IRS-provided preparation times by one of the above-cited estimates of the value of taxpayer time may be inaccurate because: (1) the current estimates of how much time taxpayers spend in compliance activities may be overstated due to the growth in the use of computer and electronic technologies to assist taxpayers in their compliance efforts and due to the assumption that paid preparers are not used in performing these compliance efforts; and (2) there is no reliable measure of the average value of taxpayer time.

IRS assistance provided to taxpayers

[347] While the increase in the utilization of computer software and electronic means of tax return preparation and filing may result in less time spent complying with the Federal tax law by individual taxpayers, the increase in the amount of IRS assistance provided to taxpayers may signify either that taxpayers have increased access to IRS-provided assistance or that taxpayers are more uncertain about their tax situation than they were in the past and, as a result, are seeking more assistance. The following table shows how assistance provided by the IRS has increased from 1990 to 1999.

Table 4. -- IRS Assistance Provided Individual Income Taxpayers

______________________________________________________________________

D. EFFECT OF COMPLEXITY ON PERCEIVED FAIRNESS OF THE FEDERAL TAX SYSTEM

[349] Complexity in the tax laws obscures the actual tax base and creates uncertainty that may reduce taxpayer perceptions of fairness in the Federal tax system in several ways. First, ambiguity in the tax laws can result in disparate treatment of similarly situated taxpayers and can lead individual taxpayers to believe that they bear a disproportionate tax burden. Second, taxpayers may believe that complexity creates opportunities for manipulation of the tax laws by other taxpayers, and confers an advantage for taxpayers who are willing and able to obtain professional advice on reducing their tax liabilities. Third, taxpayers may become disillusioned with tax policy that appears to be inconsistent because of the uncertainty that emanates from complex tax laws. In addition to causing inadvertent noncompliance, complex and confusing tax laws can instill cynicism among taxpayers, which ultimately can lead to intentional noncompliance.

E. EFFECT OF COMPLEXITY ON TAX ADMINISTRATION

[350] Complexity in the Federal tax system can adversely affect not only the ability and willingness of taxpayers to comply with the tax laws, but also can affect the ability of the IRS and its employees to properly administer the tax laws. Complex tax laws can be difficult for the IRS to explain to taxpayers in a concise and understandable manner in forms, instructions, publications, and other guidance. Even with an increasing reliance on return preparation computer software by taxpayers and tax return preparers, complex tax laws can increase the administrative burden of identifying and correcting computational mistakes made by taxpayers. As a result, the need to administer complex tax laws can increase the need for larger IRS budgets and higher IRS personnel levels than would otherwise be required with less complexity in the tax laws.

[351] Complexity in the tax laws also can make it difficult for the IRS to adequately train its employees and hire new employees with the necessary skill levels, thus inhibiting the quality of service that IRS employees can provide to taxpayers. In other words, IRS employees cannot explain complex tax laws to taxpayers if they themselves do not understand the laws. The IRS provides various channels for taxpayers to obtain technical assistance in the application of the tax laws, including call sites that assist taxpayers who telephone the IRS with tax law questions and the Electronic Tax Law Assistance program that enables taxpayers to obtain answers from the IRS to tax law questions via electronic mail. ¹⁷⁰

[352] With regard to the call sites, IRS data indicates that taxpayers received accurate tax law information 73.8 percent of the time for the 1999 filing season and 71.9 percent of the time for the 2000 filing season, against IRS goals of 85 and 80 percent for the 1999 and 2000 filing seasons, respectively. ¹⁷¹ With regard to the Electronic Tax Law Assistance program, IRS data indicates that the IRS correctly responded to electronic submissions 76 percent of the time between January and April of the 2000 filing season, against an IRS goal of 79 percent for all of fiscal year 2000. ¹⁷²

[353] Several factors may account for the tax law accuracy rates of the IRS call sites and the Electronic Tax Law Assistance program. Nevertheless, the actual and targeted accuracy rates both suggest that the complexity of the tax system fundamentally impedes tax administration by the IRS, including efforts by the IRS to provide taxpayers with accurate information concerning the tax laws.

IV. EFFORTS OF FOREIGN COUNTRIES TO SIMPLIFY THEIR TAX LAWS

[354] The Joint Committee staff asked the Congressional Research Service to review the efforts of foreign countries to simplify their tax laws. The Congressional Research Service reported back with findings and documents relating to tax simplification efforts in Australia, Indonesia, Iran, Japan, New Zealand, the Russian Federation, Sweden, and the United Kingdom. The findings and documents were prepared by the Law Library of the Library of Congress. The Law Library summarized the approaches taken by these countries and assessed the effectiveness of their simplification efforts. ¹⁷³

[355] Tax simplification in these countries was (and is being) pursued for different reasons and in different ways. Indonesia, Iran, Japan, and the Russian Federation sought simplification largely through substantive tax reform. By contrast, Australia, New Zealand, and the United Kingdom undertook simplification to make the tax laws easier to understand, not primarily to change underlying tax policy. Sweden's simplification efforts were directed at easing administration and the filing of tax returns.

[356] The countries sampled by the Congressional Research Service not only represent diverse legal systems, but the reasons for simplification and the relative condition of the tax laws in each country are distinct. Accordingly, although the experience of simplification efforts in the countries sampled offers anecdotal insights, the direct relevance of such experiences to the simplification of U.S. law is not always clear. With that caveat, a summary of the Congressional Research Service's findings follows.

A. SIMPLIFICATION BY SUBSTANTIVE TAX REFORM

Indonesia

[357] Upon obtaining independence from the Dutch in 1949, Indonesia inherited an outdated system of taxation. Thirty-five years later, the 1984 Income Tax Law attempted to simplify and reform the system by pursuing the goals of increased revenue, distribution of income and efficiency. The reform efforts were undertaken with the understanding that no part of the old system had to be retained.

[358] The 1984 Income Tax Law made many substantive reforms. It defined "tax subject" to include both individuals and businesses. It applied the same rate of tax to most forms of income, including wages, salaries, honoraria, interest, dividends, royalties, net profits and capital gains. (Prior to the change, such different kinds of income were subject to different rates of tax.) The Tax Law provided that all gross income would be consolidated into a single tax return, instead of several. It reduced tax brackets to three and reduced the top bracket from 50 percent to 35 percent. It limited withholding of income tax to wages, salaries, interest, dividends and royalties, instead of all forms of income. Other changes included simplification of the rules on depreciation, the fringe benefit deduction (and the corresponding exclusion from income) and the elimination of certain tax credits. Finally, the Act changed the audit system to a random and selective system of audit instead of mandatory audit of all tax returns.

[359] The Indonesian reform effort appears to have been largely successful. The first few years following the reforms showed increased revenues and improved administration, which has continued. However, more recent years have shown huge amounts of uncollected taxes and the introduction of loopholes that have begun to erode the tax system.

Iran

[360] Post-revolutionary Iran sought to simplify and improve its tax system in 1988 in part by reducing the number of elements to be considered in the assessment of tax on business from sixteen to six and by permitting the payment of taxes in installments over three years. The new law also aimed to increase compliance by rewarding certain taxpayers who correctly kept required books and properly paid their taxes over three years with a nine percent credit over such period. In addition, the law erased 80 percent of assessed penalties if taxpayers reached settlement with the authorities and paid their taxes.

Data on the success of the law was not available.

Japan

[361] After World War II, at the initiation of the United States, Japan substantially reformed its tax system by adopting a global income tax with progressive rates and a self-assessment system.

[362] There are two notable continuing features of Japan's early post-war system. First, the tax law requires withholding of tax by those who pay wages, salaries, interest and other income specified by law. Such extensive withholding advances simplification and keeps the government's administrative costs low. Second, a taxpayer who agrees to keep account books and records in a manner specified by the authorities can file a so-called "Blue Return." With a Blue Return, as long as errors cannot be found in the books and records, the tax authorities may not reassess the taxpayer.

[363] Following the U.S. tax reform of 1986, Japan too looked to reform its own system. The 1988 reforms reduced the number of tax brackets from twelve to five, reduced tax rates (including reducing the top rate from 60 percent to 50 percent), increased standard personal allowances and exemptions, and reduced the corporate income tax rate. Consistent with the principles of the 1988 law, a 1994 tax law made further rate changes, mainly for the benefit of the middle class.

[364] Although the reforms successfully reduced the tax burden on the middle class, and the withholding system continues to promote efficiency in administration, critics of the reforms urge a further flattening of the tax rates and inclusion of investment income in the definition of ordinary income.

Russian Federation

[365] Since the fall of the Soviet Union, Russia's tax system has been characterized as corrupt, complicated and rife with evasion and under-collection. Pursuant to a 1991 law, taxpayers were required to register with local tax agencies, keep detailed records of revenues and expenses, submit burdensome paperwork and meet other legal requirements.

[366] In 1998 and 2000, Russia adopted a new tax code that makes significant changes to the tax system. New rules include a 13 percent flat income tax for individuals instead of a tax based on a sliding 12 percent-30 percent scale. The new code provides for exclusions from income for pensions, compensation payments, grants and targeted social assistance. The new code imposes a rate of 35 percent on certain income, e.g. gambling income, insurance payments and interest on bank deposits with certain specified interest rates. One major reform provides that income tax is no longer based on the type of taxpayer (e.g., employee, collective farmer, entrepreneur) or on the form of ownership or source of the object of taxation. The new code preserves progressive tax rates on luxury items and property in an effort to bolster revenue and achieve equity. On the business side, the code provides a flat rate of 30 percent on profits for all businesses, simplifies the rules for deductions of business expenses, and provides that general accounting procedures are to be used in determining profits and expenses for tax purposes. The new code reduces the four percent payroll tax on business revenue to one percent of the business's profit.

[367] Because the enactment of the new Russian tax code was so recent, it is too early to assess the success of the reform effort.

B. SIMPLIFICATION BY ADMINISTRATIVE REFORM: REWRITING THE TAX LAW AND/OR EASING TAXPAYER COMPLIANCE

Australia

[368] Prior to 1997, the Australian income tax for individuals and companies was governed by a 1936 Act that had become complex and confusing. A tax law that was 126 pages in length in 1936 had expanded to nearly 6,000 pages. One reason for the length resulted from the practice of adding new material to the legislation, not to the regulations; another was that strict judicial interpretation of the letter of the law, in favor of interpreting the law consistent with its purpose, led drafters to include yet additional detail to legislation. Whatever the reason, the length and complexity of the law meant that it could not be effectively administered or complied with.

[369] The unworkability of the tax law persuaded lawmakers to undertake a significant reform effort. In 1993, the Tax Law Improvement Project was established to redraft the income tax laws to make them easier to read and understand. The Tax Law Improvement Project consisted of about 50 professionals and largely completed its work in 1997 with passage of the Income Tax Assessment Act.

[370] The Tax Law Improvement Project set out literally to rewrite the tax law by using "plain" English, for example, by consistently using the active voice and present tense and even by addressing the taxpayer as "you" in the legislation. The Tax Law Improvement Project's rewrite revised specific sections mindful of their likely audience. Remote and technical provisions generally would be read by sophisticated readers and therefore did not require as significant a. rewrite. The Tax Law Improvement Project also improved cross referencing, included explanatory diagrams and other graphic materials in the legislation, added new sections to the law that list the law's core concepts, provided general statements of key principles at the beginning of sections, made defined terms easier to locate, used more examples, and made the typeface easier to read. The rewrite also restructured the 1936 Act, dividing it into chapters that moved from general principles to particular situations. The goal was not to change underlying tax policy but to create a better more "user-friendly" document. The foreseen benefits were to reduce compliance and administrative costs, provide better resources for understanding the law, improve voluntary compliance, make the law fairer, and improve and clarify the debate about tax policy.

[371] No comprehensive assessment of the effectiveness of the Tax Law Improvement Project's efforts is available. Although the rewrite did shrink the size of the tax law, it still runs into the thousands of pages. Isolated criticisms include that the reform should have included a review of tax policy, that changes in wording will result in unintended but unavoidable changes in meaning, and that most users of the tax law are in fact tax professionals and that the rewrite is inaccurate and patronizing. Despite such criticisms, it seems likely that at a minimum the new law will reduce compliance and administrative costs and improve taxpayer compliance.

New Zealand

[372] Substantive and administrative tax simplification consistently has been an issue for successive New Zealand governments. Although no major substantive reform effort has been passed, in 1998 and 1994 New Zealand enacted significant administrative changes.

[373] The 1998 effort changed the tax collections requirements to eliminate the need for approximately 1.2 million wage and salary earners to file an annual tax return. Salaried employees now give employers information that enables employers to deduct the appropriate amount of tax in most cases, obviating the need for the taxpayer to file a return (though if a taxpayer overpays, the taxpayer can file for a refund). Employers have complained of the costs of this new system.

[374] The 1994 reforms divided existing tax legislation into three separate statutes -- the Income Tax Act (substantive provisions), the Tax Administration Act (collections) and the Taxation Review Authorities Act (appeals and rulings). The Income Tax Act reordered existing law to reflect the process of completing a tax return, with a numeric sequence following the steps of filing returns. The reordering also intended to improve cross-referencing. In addition, the Income Tax Act began a project to rewrite the tax laws, similar to the Australian effort. Principles to guide the rewrite include the adoption of a "plain language" style, drafting to clarify the scheme, purpose and policy intent of each provision, and use of a consistent format throughout. The audience for the rewrite is tax professionals.

[375] The reform efforts have been largely non-controversial. However, the tax rewrite project has not yet made much progress. Two Parts of the Income Tax Act have been rewritten but one is only two pages and the other is a 25 page legal summary. Progress on rewriting other Parts is slow.

Sweden

[376] In general, under the Swedish system, individuals and entities are required to file a tax return only if income is greater than the standard deduction. For those that have to file, there are two general kinds of returns: the special return and the simplified return. Most taxpayers use the simplified return (there is a special simplified return for business). Partnerships and closely held corporations file the special return.

[377] The simplified return is the product of a 1995 change to the law. With a simplified return, employers, banks, insurance companies, credit institutes and the like are obliged to file "income statements" with the authorities and the taxpayer. The income statements contain information about salaries, pensions, interest, dividends, capital gain and other forms of income. They also contain information about some deductible expenses, such as premiums paid for pension insurance. The tax authorities use the data on the income statements to complete a tax form for the taxpayer including a calculation of tax owed. The authorities send the completed form to the taxpayer, who checks its accuracy. If the form is accurate, the taxpayer signs the form and returns it to the authorities with any payment to follow at a later date. If there are mistakes or incomplete information (e.g., additional deductions), the taxpayer corrects the form and adds any necessary information. Typically, 60 percent-65 percent of all simplified forms are returned to the tax authorities without any change.

[378] The simplified return has received a very positive response from taxpayers, many of whom find that the pre-completed forms contain reliable information and that they are able to check and complete the form without professional help. The authorities generally appear to like the form because it lowers their administrative costs and results in a higher quality of taxation. However, there is more time pressure on personnel to examine returns and a need to educate personnel about the form.

United Kingdom

[379] A provision of the 1995 Finance Act required the United Kingdom tax authorities ("Inland Revenue") to prepare a report on tax simplification in the United Kingdom. The report recommended rewriting the tax laws, which consist of over 6,000 pages. Accordingly, in 1996 Inland Revenue embarked on a project to simplify its tax law through a major rewrite and restructuring of existing provisions. The goal of the ongoing project is to make the tax law clearer and easier to use without sacrificing its general effect. Since 1996, Inland Revenue has published a number of reports about the project but progress on the rewrite has been slow.

[380] Like the Australian project, the revision will be in "plain" or colloquial language and will utilize short sentences, active voice, the positive in preference to the negative, and will avoid archaic vocabulary and jargon. Examples include: regular use of the possessive, for instance, rather than writing "of the taxpayer," instead write "the taxpayer's"; and to address the taxpayer as "you" in the legislation. The revision aims to restructure the law into a more logical format, with seven main acts likely -- Income Tax, Corporation Tax, Capital Allowances, Capital Gains, Stamp Duties, Inheritance Tax and Management. Existing specific provisions will be reorganized to fit within one of these seven categories and similar rules will be located together. In the rewrite, better use will be made of cross-referencing, sometimes including explanations of the cross-reference. The rewrite also will likely contain general explanatory materials, for example, overviews of each Part of the legislation and commentary on separate clauses. Such explanations will be intended to help the reader understand the general intent of the law.

[381] There continues to be considerable debate about the extent to which the rewrite should use "purposive drafting." Purposive drafting techniques result in shorter law because broad guidelines and a statement of purpose are preferred to detailed examples. But purposive drafting would likely lead to a loss of certainty and to dependence on courts or increased reliance on administrative rulings, resulting in a loss of democratic accountability and an expanded interpretive role for Inland Revenue. Inland Revenue also recognizes the inherent problem of inadvertent policy change through rewrite. In part to counter this issue, the rewrite project has proceeded carefully, in close consultation with professionals and taxpayers. Consultation with taxpayers and the professions also is seen as crucial to ensure the legitimacy of the rewrite project in the long term; however, it also slows the pace of progress.

[382] Inland Revenue studied the Australian and New Zealand experiences and concluded that revision, although important, would not alone secure the full benefits of simplification. Real improvements to clarity and accessibility would require minor changes in underlying substance, for example by rationalizing and modernizing definitions and deleting redundant or outdated material. Needed changes to policy, however, would not be crystallized until the rewrite was underway and would require approval of Parliament.

[383] In a 1999 report on the progress of the project, Inland Revenue concluded that, although the public was supportive and drafts of revisions of sections had been praised, the task of rewriting the law with full consultation was more difficult and time consuming that originally thought. Still, the potential benefits of clearer tax law and the spillover effects of introducing modem drafting techniques to finance and other legislation are considered to be great. The project proposes to introduce a first rewritten Income Tax Bill to Parliament in November 2002.

APPENDIX A. --

Academic Advisors to Joint Committee on Taxation For Study of Overall State of the Federal Tax System

     NAME                         INSTITUTION

² Section 1203(c) of the Revenue Bill of 1926.

³ Report of the Joint Committee on Internal Revenue Taxation, Volumes I, II, and III (1928).

⁴ Id., at 5.

⁵ Pub. Law No. 94-455.

⁶ Joint Committee on Taxation, Issues in Simplification of the Income Tax Laws (JCS-57-77), September 19, 1977.

⁷ Id., at 9.

⁸ Sec. 8022(3)(B) of the Code (as added by sec. 4002(a) of the IRS Reform Act).

⁹ Written Testimony of the Honorable Bill Archer, Chairman, House Committee on Ways and Means, and the Honorable Bill Roth, Chairman, Senate Committee on Finance, on Behalf of the Joint Committee on Taxation Before the Subcommittee on Legislative of the House Committee on Appropriations, United States House of Representatives, February 3, 1999.

¹⁰ Pub. Law No. 104-52, sec. 637.

¹¹ A Vision for a New IRS: Report of the National Commission on Restructuring the Internal Revenue Service, June 27, 1997.

¹² Id., at 35.

¹³ During the 106th Congress, the Joint Committee staff prepared a complexity analysis for 10 bills. Since the enactment of the requirement for a tax complexity analysis, a point of order has not been raised with respect to any bill.

¹⁴ Annual Report from the Commissioner of the Internal Revenue Service on Tax Law Complexity, June 5, 2000.

¹⁵ National Taxpayer Advocate's FY2000 Annual Report to Congress.

¹⁶ This criterion also limited the scope of the study to the present-law income tax. Alternative tax systems and their possible effects on simplification were not examined.

¹⁷ In addition, the General Accounting Office identified 53 other sections that could not be placed into one of the above categories.

¹⁸ Sec. 7805(b).

¹⁹ Appendix C, at 37.

²⁰ For example, though published in 2000, the regulations regarding transfers to regulated investment companies and real estate investment trusts were retroactive to June 10, 1987.

²¹ Sec. 6110(k)(3).

²² See Appendix D.

²³ See Appendix C at 31.

²⁴ Id. at 32.

²⁵ See a more detailed discussion of this issue in Volume II, Part Three, XVI.B.

²⁶ Golsen v. Commissioner, 54 T.C. 742 (1970).

²⁷ Appendix C, Table II.1, at 38, and Table II.2, at 62.

²⁸ Appendix C, Table II.1, at 38.

²⁹ Department of Treasury, Internal Revenue Service, "Charities and Other Tax Exempt Organizations, 1997," Statistics Of Income Bulletin, (20:2), p.47.

³⁰ Appendix C, Table IV.2, at 108.

³¹ Appendix C, Table IV.5, at 110.

³² This examination could be extended to include errors committed by IRS in efforts, including providing advice to taxpayers, to ensure compliance.

³³ Ernst & Young, The Ernst & Young Tax Guide 2001, at xxi.

³⁴ A tax controversy may eventually lead to clarification, or it may add to complexity by triggering disputes in other areas. Some controversies are relatively short in duration and result in an illumination of the law that lasts for decades. Other controversies inefficiently drain IRS and taxpayer resources. Efficiency judgments on controversies are rendered best ex post, and must be balanced by other concerns, such as taxpayer equity.

³⁵ Hand, Thomas Walter Swan, 57 Yale Law Journal 167, 169 (1947).

³⁶ The numerous sources of tax law alone are a source of complexity -- in order to research or validate a point of law, more than one source of tax materials should be consulted. See Paul, The Sources of Tax Complexity: How Much Simplicity Can Fundamental Tax Reform Achieve?, 76 N.C.L. Rev. 151, 154 (Nov. 1997) ("Intuitively, tax complexity refers in part to the regime's 'complication' -- the number and detail of the legal authorities that define the regime.").

³⁷ The Joint Committee staff recommends redrafting the section to eliminate convoluted language and to improve readability.

³⁸ See, Rook, Laying Down the Law: Canons for Drafting Complex Tax Legislation, Tax Notes (Jan. 31, 1994).

³⁹ McMahon, Reflections on the Regulations Process: Do the Regulations have to be Complex or is Hyperlexis the Manna of the Tax Bar?, 51 Tax Notes 1441 (June 17, 1991).

⁴⁰ Manning, Hyperlexis: Our National Disease, 71 Nw. U.L. Rev. 767 (1977) (coining the phrase "hyperlexis" to describe the "pathological condition caused by an overactive law-making gland"); Schwidezky, Hyperlexis and the Loophole, 49 Okla. L. Rev. 403 (1996); Lipton, We Have Met the Enemy and He is Us: More Thoughts on Hyperlexis, 47 Tax Law. 1 (1993); McMahon, Reflections on the Regulations Process: Do the Regulations Have to Be Complex or is Hyperlexis the Manna of the Tax Bar?, 51 Tax Notes 1441 (June 17, 1991); Henderson, Controlling Hyperlexis -- The Most Important 'Law and. . .', 43 Tax Law. 177 (1989). See also Paul, The Sources of Tax Complexity: How Much Simplicity Can Fundamental Tax Reform Achieve?, 76 N.C.L. Rev. 151, 154 (Nov. 1997) (referring to a "legal cultural taste for complication").

⁴¹ See, e.g., Treasury Regulations under Code sections 263A (uniform capitalization rules), 338 (stock purchases treated as asset acquisitions), 704(b) (partner allocations), 1271-86 (original issue discount).

⁴² Manning, Hyperlexis and the Law of Conservation of Ambiguity: Thoughts on Section 385, 36 Tax Law. 9 (1982).

⁴³ Kovach, Bright Lines, Facts and Circumstances Tests, and Complexity in Federal Taxation, 46 Syracuse L. Rev. 1287 (1996).

⁴⁴ Taxpayers may desire a "comfort" ruling because the consequence of an IRS audit or subsequent adverse determination may be severe.

⁴⁵ See the discussion, below, of the effect of the budget process on complexity.

⁴⁶ See Appendix D.

⁴⁷ Id.

⁴⁸ See Pearlman, The Tax Legislative Process: 1972-1992, 57 Tax Notes 939 (1992) ("It is not surprising . . . that taxpayers, as well as tax professionals both within and outside government, have been overwhelmed by the thousands of changes in the law. It also should. not be surprising that an 18-year period of annual tax legislation has resulted in considerable instability in the law.").

⁴⁹ Section 385 was enacted in 1969. Treasury issued Proposed Regulations in 1980 and final regulations in 1981. However, in response to criticism of the regulations, they were withdrawn in 1983 and have not been replaced by new regulations.

⁵⁰ See Appendix D.

⁵¹ See, e.g., sec. 402(d)(2)(E) (regarding the taxation of lump sum distributions); sec. 475(e) (regarding mark to market accounting method for dealers in securities); sec. 1202(k) (regarding the exclusion for gain from certain small business stock).

⁵² See, e.g., sec. 355(e)(3)(A); sec. 514(c)(9)(G); sec. 684(a); sec. 960(a)(1).

⁵³ See the Joint Committee staff recommendation with respect to the treatment of such attorneys' fees in Section II.F. of Part Three.

⁵⁴ Handler, Budget Reconciliation and the Tax Law: Legislative History or Legislative Hysteria?, 37 Tax Notes 1259, 1266 (1987) ("substantive tax revision solely for revenue raising purposes is not a sensible reform process . . . [it] cannot be effected in a helter- skelter fashion under circumstances where the only rationale for developing any reform is the revenue-raising function of the budget reconciliation process"); Nolan, Federal Bar Association, The Condition of the Tax Legislative Process, 39 Tax Notes 1581, 1583 (1988) ("we have departed from an orderly and predictable process for identifying the legislative issues in advance and dealing with them in a well organized way).

⁵⁵ McLure, The Budget Process and Tax Simplification/Complication, 45 N.Y.U. Tax L. Rev. 25, 80 (1989).

⁵⁶ Id. at 81; Pearlman, The Tax Legislative Process: 1972- 1992, 57 Tax Notes 939, 940 (1992).

⁵⁷ General Accounting Office, Tax Policy: Tax Expenditures Deserve More Scrutiny (GAO/GGD/AIMD-94-122, June 3, 1994).

⁵⁸ See Slemrod & Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate Over Tax Reform 139 (1996) ("[O]ur tax system is now an awkward mixture of a revenue-raising system plus scores of incentive programs, and is much more complicated than it would be if its only function were to raise revenue in the most equitable and cost-efficient way possible.") (hereinafter "Slemrod & Bakija").

⁵⁹ For a detailed explanation of tax expenditures, see Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2001-2005 (JCS-1-01), April 6, 2001.

⁶⁰ There are a few tax expenditures that have statutorily imposed limits. One example is the tax credit for low-income rental housing. This credit is available only to those who have received credit allocations from State housing authorities. There are statutory limits on the total amounts of credit allocations that the States can make each year.

⁶¹ See Thuronyi, Tax Expenditures: A Reassessment, 1988 Duke L.J. 1155 (1988) ("The concept of 'tax expenditures' holds that certain provisions of the tax laws are not really tax provisions, but are actually government spending programs disguised in tax language.") (hereinafter "Thuronyi"). See also Surrey & McDaniel, Tax Expenditures 1 (Harvard University Press 1985).

⁶² Pub. Law No. 93-344. See Surrey, Pathways to Reform 179- 180 (1973) (arguing that many tax expenditures would be repealed once they were recognized as disguised government outlay programs) (hereinafter "Surrey").

⁶³ A tax expenditure estimate is not the same as a revenue estimate for the repeal of the tax expenditure provision for two reasons. First, tax expenditure estimates do not incorporate any changes in taxpayer behavior, whereas revenue estimates incorporate the effects of the behavioral changes that are anticipated to occur in response to the repeal of a tax provision. Second, tax expenditure estimates are concerned with changes in the tax liabilities of taxpayers. Because the tax expenditure focus is on tax liabilities as opposed to Federal government tax receipts, there is no concern for the timing of tax payments. Revenue estimates are concerned with changes in Federal tax receipts, which are affected by the timing of tax payments.

⁶⁴ However, the Joint Committee staff emphasizes in its estimates that no judgment is made, nor any implication intended, about the desirability of any special tax provision as a matter of public policy.

⁶⁵ See Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2001-2005 (JCS-1-01), April 6, 2001.

⁶⁶ Thuronyi, at 1155; Bittker, The Tax Expenditure Budget -- A Reply to Professors Surrey and Hellmuth, 22 Nat'l Tax J. 538, 542 (1969) (Tax expenditures "necessarily reflect[] ad hoc value judgments, since a value-free 'correct tax structure' is impossible."); McIntyre, A Solution to the Problem of Defining a Tax Expenditure, 14 U.C. Davis L. Rev. (1980).

⁶⁷ Compare Surrey, at 131-133 (describing and then refuting arguments supporting tax expenditures on administrative efficiency grounds), Driessen, A Qualification Concerning the Efficiency of Tax Expenditures, 33 J. Pub. Econ. 125 (1987) (suggesting that tax expenditures are not more efficient than direct government outlays), and Steuerle, Summers on Social Tax Expenditures, 89 Tax Notes 1639 (Dec. 18, 2000) (discussing weaknesses of arguments by former Treasury Secretary Summers for social tax expenditures), with Zelinsky, Efficiency and Income Taxes: The Rehabilitation of Tax Incentives, 564 Tex. L. Rev. 973 (1986), Zelinsky, James Madison and Public Choice at Gucci Gulch: A Procedural Defense of Tax Expenditures and Tax Institutions, 102 Yale L.J. 1165 (1993), Feldstein, A Contribution to the Theory of Tax Expenditures: The Case of Charitable Giving, in The Economics of Taxation 99 (Aaron & Boskin eds., 1980) (concluding that tax expenditures are generally more efficient than direct government outlays), and Steuerle, Summers on Social Tax Expenditures, 89 Tax Notes 1481 (Dec. 11, 2000) (discussing strengths of arguments by former Treasury Secretary Summers for social tax expenditures).

⁶⁸ Joint Committee on Taxation, Estimates of Federal Tax Expenditures (JCS-5-76), March 15, 1976; Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 1987-1991 (JCS-7-86), March 1, 1986.

⁶⁹ Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 1988-1992 (JCS-3-87), Feb. 27, 1987.

⁷⁰ Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2001-2005 (JCS-1-01), April 6, 2001.

⁷¹ Bittker, Tax Reform and Tax Simplification, 29 U. Miami L. Rev. 1, 10 (1974). For a detailed discussion of limitations on individual income tax benefits and complexity in general, see Joint Committee on Taxation, Overview of Present Law and Issues Relating to Individual Income Taxes (JCX-18-99), April 14, 1999, at 55-84.

⁷² Education tax incentives are discussed in detail in Section II.G. of Part Three.

⁷³ The income-based phase-outs are discussed in detail in Section II.C. of Part Three.

⁷⁴ See Paul, The Sources of Tax Complexity: How Much Simplicity Can Fundamental Tax Reform Achieve?, 76 N.C.L. Rev. 151 (Nov. 1997) (concluding that a tax regime committed to raising significant revenues equitably is inevitably complex); Slemrod & Bakija, at 83 ("Fine-tuning tax liability and ensuring progressivity inevitably complicate the tax process, and abandoning these goals can allow significant simplification.").

⁷⁵ See Pollack, The Failure of U.S. Tax Policy: Revenue and Politics 203 (1996) ("The factor most often cited as responsible for the increased complexity in the tax laws is the perceived increase in the complexity of the 'world' in general and of the 'economy' in particular.").

⁷⁶ See Halperin, Are Anti-Abuse Rules Appropriate?, 48 Tax Lawyer 807, 811 (1985) ("The tax law will always be an uneasy compromise between efforts to achieve equity and limit efficiency losses at a reasonable level of complexity.").

⁷⁷ See Slemrod & Bakija, at 137 ("Substantial simplification will require that we give up on the notion that the bill we pay to the government must be personalized in great detail, and settle instead on rough justice only.").

⁷⁸ United States v. Irvine, 511 U.S. 224 (1994); United States v. Mitchell, 403 U.S. 190 (1971); Commissioner v. Stern, 357 U.S. 39 (1958); Helvering v. Stuart, 317 U.S. 154 (1942); Morgan v. Commissioner, 309 U.S. 78, 80-81 (1940); Burnet v. Harmel, 287 U.S. 103 (1932); Note, The Role of State Law in Federal Tax Determinations, 72 Harv. L. Rev. 1350, 1351 (1959) ("[T]he substantive rule is federal, and state law merely establishes some of the facts to which the court applies federal law in order to reach its conclusions.").

⁷⁹ Marty-Nelson, Taxing Offshore Asset Protection Trusts: Icing on the Cake?, 15 Va. Tax Rev. 399, 441 (Winter 1996) ("[M]any times domestic taxpayers secure different tax results owing to a domicile in one state or another. This disparity among domestic taxpayers stems from the struggle for federal tax purposes of achieving a proper balance between tax uniformity and deference to state laws." (citations omitted)).

⁸⁰ Compare Estate of Millikin v. Commissioner, 125 F.3d 339 (6th Cir. 1997), Estate of Love v. Commissioner, 923 F.2d 335 (4th Cir. 1991), Marcus v. DeWitt, 704 F.2d 1227 (11th Cir. 1983), Hibernia Bank v. United States, 581 F.2d 741 (9th Cir. 1978), Estate of Smith v. Commissioner, 510 F.2d 479 (2d Cir. 1975), and Pitner v. United States, 388 F.2d 651 (5th Cir. 1967), with Estate of Jenner v. Commissioner, 577 F.2d 1100 (7th Cir. 1978).

⁸¹ Drye v. United States, 528 U.S. 49 (1999), affg. Drye Family 1995 Trust v. United States, 152 F.3d 892 (8th Cir. 1998). Compare Leggett v. United States, 120 F.3d 592 (5th Cir. 1997), and Mapes v. United States, 15 F.3d 138 (9th Cir. 1994).

⁸² 387 U.S. 456 (1967) (Douglas, J., Harlan, J., and Fortas, J., dissenting).

⁸³ Id. at 465.

⁸⁴ Id.

⁸⁵ Steinkamp, Estate and Gift Taxation of Powers of Appointment Limited By Ascertainable Standards, 79 Marq. L. Rev. 195, 238 (Fall 1995) ("Bosch failed to provide the certainty that the Court hoped to achieve."); Rehnquist, Taking Comity Seriously: How to Neutralize the Abstention Doctrine, 46 Stan. L. Rev. 1049, 1097 (May 1994) ("In sum, federal judges have in the past fifty years grown increasingly comfortable sitting 'in effect' as state courts . . .."); Caron, The Federal Courts of Appeals' Use of State Court Decisions in Tax Cases: "Proper Regard" Means "No Regard", 46 Okla. L. Rev. 443, 445 (Fall 1993) ("The courts of appeals thus have undermined Bosch by giving 'no regard' to the lower state court's application of state law, despite the Bosch Court's intent to use the 'proper regard' test to balance the competing policies."); Durham, California Dreamin': Protective Legislation: Does It Work? Does It Need Revision? Can It Be Effective?, 26 Inst. on Est. Plan. 7-1, 7-28 (1992) ("'Proper regard' has been used to justify multiple approaches: that state court rulings are to be disregarded and are not even admissible; that state court decisions are relevant evidence even if they are not adversary; that state court decisions should be followed if they correctly interpret state law; that a state court decision may be noted but then the federal court should decide the case as if the state court did not even exist.").

⁸⁶ See Lakeshore Nat'l Bank v. Coyle, 296 F. Supp. 412, 417- 418 (N.D. Ill. 1968), rev'd, 419 F.2d 958 (7th Cir. 1969) (stating that Bosch required the court to give "proper regard" to a State probate court decree -- "whatever that means".). Compare Morgan v. United States, 79-2 U.S.T.C. para. 13,308, at 88,763 (C.D. Cal. 1979) (stating that lower State court decision was "not relevant"), and Van Nuys v. United States, 75-2 U.S.T.C. para. 13,081, at 88,815 (C.D. Cal. 1975) (stating that lower State court decision was "irrelevant"), with First Nat'l Bank v. United States, 69-1 U.S.T.C. para 12,589, at 84,892 (D.N.M. 1969), affd, 422 F.2d 1385 (10th Cir. 1970) ("Bosch does not require that the federal district court make an independent determination of the property interest. If the federal district court finds from the records of the state proceedings that state law was followed, then there is no reason why it has to re- litigate the state case.").

⁸⁷ An overemphasis on State law in the Federal tax rules can encourage potential arbitrage of State laws by taxpayers, as well as the enactment and interpretation of State law by State legislatures and courts in a manner that inappropriately focuses upon providing Federal tax savings for their own residents. See Gans, Federal Transfer Taxation and the Role of State Law: Does the Marital Deduction Strike the Proper Balance?, 48 Emory L.J. 871, 876-883 (Summer 1999) (citing the sec. 1014(b)(6) community property basis rules, the sec. 2056(a) marital deduction passing requirement, the sec. 2631 generation-skipping tax exemption rules, and the sec. 2704(b) special valuation rules as examples of overemphasis on State law that gives rise to such effects).

⁸⁸ In White v. United States, 650 F. Supp. 904 (W.D.N.Y. 1987), rev'd, 853 F.2d 107 (2d Cir. 1988, cert. dismissed per curiam, 493 U.S. 5 (1989), the Court granted a writ of certiorari to address the continuing viability of the Bosch standard, but dismissed the writ as improvidently granted after hearing oral argument.

⁸⁹ The community property States are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Even beyond the estate and gift tax rules and the tax rules concerning filing status, there are many other examples of the interaction between State community property laws and the current Federal tax rules, including (1) sec. 32(c)(2) (earned income computed without regard to community property laws for purposes of earned income tax credit), (2) sec. 219(f)(2) (maximum deduction for qualified retirement contributions computed without regard to community property laws), (3) sec. 220(b)(4)(C) (limitation on deduction for contribution to Archer MSA computed without regard to community property laws), (4) sec. 303(b)(2)(B) (special rule for distributions in redemption of stock of 2 or more corporations to pay death taxes applied as if surviving spouse's community property interest in stock included in determining value of decedent's estate), (5) sec. 402(e)(4)(D)(iii) (certain rules relating to taxability of beneficiaries of exempt employees' trust applied without regard to community property laws), (6) sec. 403(b)(2)(D)(ii) (certain rules relating to taxability of beneficiaries of annuities purchased by sec. 501(c)(3) organizations or public schools applied without regard to community property laws), (7) sec. 408(g) (rules for IRAs applied without regard to community property laws), (9) sec. 414(p)(1)(B)(9)(ii) ("domestic relations order" defined to include any judgment, decree, or order made pursuant to community property law), (10) sec. 448d)(4)(A) (community property laws disregarded in applying qualified personal service corporation exemption from limitations on cash method of accounting), (11) sec. 457(e)(7) (community property laws disregarded in computing includible compensation limitation on deferred compensation plans of State and local government and tax-exempt organizations), (12) sec. 530(f) (rules for education IRAs applied without regard to community property laws), (13) sec. 879 (rules for treatment of certain community income of nonresident foreign individuals), (14) sec. 911(b)(2)(C) (rules for treatment of community income of U.S. citizens or residents living abroad), (15) sec. 932(d) (rules for coordination of U.S. and Virgin Islands income taxes on community income reported on joint tax returns), and (16) sec. 1402(a)(5) (definition of net earnings from self-employment with respect to community income).

⁹⁰ Act of October 21, 1942, 56 Stat. 798.

⁹¹ Revenue Act of 1948, 62 Stat. 110.

⁹² Pub. Law No. 97-34.

⁹³ See sec. 2056.

⁹⁴ These rules include (1) sec. 1014(b)(6) (rules relating to basis of community property acquired from decedent), (2) sec. 2032A(e)(10) (application of special valuation rules for qualified farm property to community property), (3) sec. 2056(b)(7)(C) (application of marital deduction to a decedent's non-participant interest in an annuity attributable to community property laws), and (4) sec. 6166(b)(2)(B)(i) (application of extension of time for payment of estate tax where estate consists of community property interest in closely held business).

⁹⁵ See Pierce v. Commissioner, 100 F.2d 397 (2d Cir. 1938) (the only advantage derived from filing a joint return is when the allowable deductions of one spouse exceed his or her income). Filing a joint tax return is optional. A spouse who wishes to avoid joint liability may file as a "married person filing separately." However, the decision to file separately will generally result in a higher combined tax liability.

⁹⁶ Lucas v. Earl, 281 U.S. 111 (1930).

⁹⁷ Poe v. Seaborn, 282 U.S. 101 (1930).

⁹⁸ Because income splitting had been available in community property States prior to 1948, a marriage bonus had already existed in community property States.

⁹⁹ 282 U.S. 101 (1930).

¹⁰⁰ S. Rep. 96-1036, (1980) at 8.

¹⁰¹ Sec. 101 of the Miscellaneous Revenue Act of 1980, Pub. Law No. 96-605.

¹⁰² Sec. 66(a).

¹⁰³ Sec. 6013(d)(3) provides that spouses who file a joint tax return are each individually responsible for the accuracy of the return and for the full tax liability. This is true even though only one spouse may have earned the wages or income reported on the return. This is "joint and several" liability. If one spouse has concealed income and failed to report it on the joint return, it may be unfair to collect the resulting tax liability from the other spouse, if the other spouse did not know of or benefit from the income. Prior to the IRS Restructuring and Reform Act of 1998 ("1998 Act"), sec. 6013(e) provided limited relief from liability for tax, interest and penalties for "innocent spouses". In the 1998 Act, sec. 6013(e) was repealed and a new sec. 6015 was enacted which provided expanded innocent spouse relief. Sec. 6015(a) (flush language) provides that innocent spouse relief is determined without regard to community property laws.

¹⁰⁴ Sec. 66(c). The relief initially granted by the provision enacted in 1980 only applied if the spouses lived apart during the entire calendar year. Congress eliminated this requirement in 1984.

¹⁰⁵ The primary disadvantage for married taxpayers who file separately in community property States is the uncertain application of sec. 66(c) by virtue of its subjective requirement that joint and several liability would be inequitable. Moreover, simple overturning the Poe rule by statute would raise other issues. Nevertheless, sec. 66 does cause complexity for married taxpayers in community property States that is not faced by married taxpayers in separate property States.

¹⁰⁶ Aquilino v. United States, 363 U.S. 509 (1960); United States v. Stonehill, 83 F.3d 1156 (9th Cir. 1996), cert. denied, 519 U.S. 992 (1996); Gardner v. United States, 34 F.3d 985 (10th Cir. 1994); Dominion Trust Co. of Tennessee v. United States, 7 F.3d 233 (6th Cir. 1993); Hoornstra v. United States, 969 F.2d 530 (7th Cir. 1992).

¹⁰⁷ United States v. Rodgers, 461 U.S. 677 (1983) (5-4 decision permitting Commissioner to seek sale of entire homestead property rather than merely delinquent taxpayer's interest in property).

¹⁰⁸ Blakeman v. United States, 997 F.2d 1054 (5th Cir. 1993); Harris v. United States, 764 F.2d 1126 (5th Cir. 1985); Tillery v. Parks, 630 F.2d 775 (10th Cir. 1980).

¹⁰⁹ At least 17 statutory tax provisions directly refer to public utilities or public utility commissions, including sec. 48(a)(3) (energy credit; reforestation credit), sec. 56(a)(1)(D) (adjustments in computing alternative minimum taxable income), sec. 115(1) (income of States, municipalities, etc.), sec. 118(c) (contributions to the capital of a corporation), sec. 136 (energy conservation subsidies provided by public utilities), sec. 142(e)(2) (exempt facility bond), sec. 168(f)(2) (normalization accounting for public utility property), sec. 172(d)(5) (net operating loss deduction), sec. 243(d)(4) (dividends received by corporations), sec. 244(a)(1) (dividends received on certain preferred stock), sec. 247 (dividends paid on certain preferred stock of public utilities), sec. 404(a)(1)(C) (deduction for contribution of an employer to an employees' trust or annuity plan and compensation under a deferred- payment plan), sec. 468A (nuclear decommissioning costs), sec. 810(c)(2)(B) (operations loss deduction), sec. 1081(f)(1) (nonrecognition of gain or loss on exchanges or distributions in obedience to orders of S.E.C.), sec. 1083 (deductions relating to exchanges or distributions in obedience to orders of S.E.C.), sec. 1341(b)(2) (computation of tax where taxpayer restores substantial amount held under claim of right), and sec. 7701(a)(33) (definitions).

¹¹⁰ Specifically, sec. 168(f)(2) provides that neither of the general accelerated depreciation methods (i.e., the Accelerated Cost Recovery System or the Modified Accelerated Cost Recovery System) apply to certain property placed in service by regulated public utilities unless the utility uses a normalization method of accounting (as defined in sec. 168(i)(9)). Public utility property that is excluded from accelerated depreciation must be depreciated using the same method as, and a depreciation period no shorter than, the method and period used by the public utility to compute its depreciation tax expense as part of its cost of service for State regulatory ratemaking purposes. Sec. 168(i)(9)(C).

The tax benefits of accelerated depreciation are considered to be normalized only if three requirements are satisfied (sec. 168(i)(9)(A)). First, the tax expense of the public utility for ratemaking purposes must be computed using the same depreciation method that is used in determining depreciation for ratemaking purposes and by using a useful life that is no shorter than the useful life used in determining depreciation for ratemaking purposes (which generally results in depreciation being determined over a relatively long useful life and using the straight-line method). Second, the difference between the actual tax expense computed using tax depreciation and the tax expense determined for ratemaking purposes must be reflected in a deferred tax reserve. Third, in determining the rate of return of a public utility, the public utility commission may not exclude from the rate base an amount that exceeds the addition to the deferred tax reserve for the period used in determining the tax expense for ratemaking purposes. In addition, any ratemaking procedure or adjustment with respect to a utility's tax expense, depreciation expense, or reserve for deferred taxes must also be consistently used with respect to the other two items and rate base (sec. 168(i)(9)(B)).

¹¹¹ H. Rep. 106-238 (July 16, 1999), at 348.

¹¹² The Federal tax rules may similarly interact with certain Federal regulatory laws that are unrelated to accounting. In Commissioner v. First Security Bank, 405 U.S. 394 (1972), the Supreme Court held that the IRS could not require a reallocation of insurance premiums from an insurance agency to an affiliate bank under the sec. 482 arm's length transfer pricing standard because the National Bank Act prohibited the bank affiliate from acting as an insurance agent.

¹¹³ Statutory reserves reported in the State regulatory annual statement are also relevant for purposes of determining the amount of tax deductible dividends paid by mutual life insurance companies (sec. 809). Similarly, property and casualty insurance companies determine gross investment and underwriting income for tax purposes based in part upon the State regulatory annual statement (sec. 832(b)).

¹¹⁴ See Treas. Reg. sec. 301.7701-3(a).

¹¹⁵ Treas. Reg. sec. 301.7701-1(a)(4). In fact, domestic eligible entities with a single owner are presumptively disregarded as separate entities for Federal tax purposes unless they elect otherwise. Treas. Reg. sec. 301.7701-3(b)(1)(ii). The assets, liabilities, income, expenses, and credits of a disregarded entity are generally treated as those of the entity's owner.

¹¹⁶ Classification of an entity as disregarded for Federal tax purposes is essentially limited to single-member limited liability companies because entities formed under State law as corporations also must be treated as corporations for Federal tax purposes, and partnerships generally require at least two owners under State law. Treas. Reg. sec. 301.7701-2(b)(1) (defining a corporation for Federal tax purposes as, among other things, a business entity organized under a State statute that refers to the entity as incorporated or as a corporation, body corporate, or body politic). With the exception of Massachusetts, all States and the District of Columbia have enacted legislation permitting the formation of single-member limited liability companies.

¹¹⁷ Treas. Reg. sec. 1.368-2(b)(1).

¹¹⁸ Prop. Reg. sec. 1.368-2(b)(1). The proposed rules would also apply to entities that are disregarded for Federal tax purposes by virtue of their status as qualified REIT (real estate investment trust) subsidiaries under sec. 856(i)(2) or qualified subchapter S subsidiaries under sec. 1361(b)(3)(B).

¹¹⁹ For personal income tax purposes, Rhode Island and Vermont fully conform to the Federal income tax base, while North Dakota offers full conformity as an alternative base.

¹²⁰ Most of these adjustments have been characterized as "reflect[ing] needs or the idiosyncrasies of (or political pressures on) state legislatures." Hellerstein & Hellerstein, State Taxation para. 20.02 (1998) (hereinafter "Hellerstein").

¹²¹ The sensitivity of States toward Federal usurpation of their taxing power has its roots in the Constitutional Convention. The Federalist Nos. 31, 32 (Alexander Hamilton). See also Pollack, The Failure of U.S. Tax Policy: Revenue and Politics 35 (1996) ("The retention of an independent power of taxation for the local state governments under the Constitution of 1789 contributed much to preserving their autonomy." (citations omitted)). On a more practical level, the residual fiscal impact on States of significant tax increases or decreases at the Federal level has deterred States from fully conforming to the Federal income tax rules. For a thorough discussion of the political and constitutional dynamics that influence State conformity to Federal income tax laws, see Hellerstein at para. 7.02.

¹²² States that have ongoing conformity to current Federal tax laws include: Alaska (corporate only), Colorado, Connecticut, Delaware, Illinois, Kansas, Louisiana, Maryland, Massachusetts (corporate only), Missouri, Montana, Nebraska, New Jersey (corporate only), New Mexico, New York, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania (corporate only), Rhode Island, Tennessee (corporate only), Utah, Vermont, and Virginia. The District of Columbia also conforms to current Federal tax laws. States that have conformed to Federal tax laws in effect as of a specified date include: Arizona, California, Florida (corporate only), Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Massachusetts (individual only), Michigan, Minnesota, New Hampshire, North Carolina, South Carolina, Texas (corporate franchise tax only), West Virginia, and Wisconsin.

¹²³ Pub. Law No. 92-512.

¹²⁴ Former secs. 6361 through 6365.

¹²⁵ Revenue Reconciliation Act of 1990, Pub. Law No. 101-508.

¹²⁶ See sec. 67(c)(2)(B)(i)(I) (2-percent floor on miscellaneous itemized deductions), sec. 72(1) (annuities; certain proceeds of endowment and life insurance contracts), sec. 83(c)(3) (property transferred in connection with performance of services), sec. 162(m) (trade or business expenses; certain excessive employee remuneration), sec. 277(b)(3) (deductions incurred by certain membership organization in transactions with members), sec. 368(a)(2)(F)(vii), sec. 401(g) (qualified pension, profit-sharing, and stock bonus plans), sec. 408(m)(3)(B) (individual retirement accounts), sec. 409(e)(4) (qualifications for tax credit employee stock ownership plans), sec. 543(a)(1)(D) (personal holding company income), sec. 731(c)(2)(B)(II) (extent of recognition of gain or loss on distribution), sec. 851 (definition of regulated investment company), sec. 852(d) (taxation of regulated investment companies and their shareholders), sec. 856(c)(5)(F) (definition of real estate investment trust), sec. 901(k)(4)(A) (taxes of foreign countries and of possessions of United States), sec. 954(h)(2)(B)(iii) (foreign base company income; active finance exception), sec. 1234B(c) (gains or losses from securities futures contracts), sec. 1246(b) (gain on foreign investment company stock), sec. 1256(g)(6)(B) (sec. 1256 contracts marked to market), sec. 1296(e)(1)(A)(i) (election of mark to market for marketable personal foreign investment company stock), sec. 1297(f)(3)(A) (passive foreign investment company), sec. 6049(b)(1)(F) and (b)(4)(J) (returns regarding payment of interest), and sec. 7603(b)(2)(D) (service of summons). The regulations contain many more direct references to Federal securities laws.

¹²⁷ For instance, several sections define dealers and brokers in various types of securities simply by reference to registration under securities laws. See secs. 165(j)(3)(B), 901(k)(4)(A), 954(h)(2)(B)(iii), and 1256(g)(8)(A). By contrast, other sections provide their own definitions of dealers and brokers that do not necessarily coincide with registered status under securities laws. See sec. 475(c)(1).

¹²⁸ For instance, simultaneous with the creation of "securities futures contracts" in the Commodity Futures Modernization Act of 2000, sec. 1234B was enacted and a number of other provisions were amended to address the tax treatment of securities futures contracts. Administratively, Treasury has issued additional regulations concerning the qualified covered call option exception to the sec. 1092 straddle rules in response to the creation of exchange- traded options with flexible terms by the Chicago Board of Exchange. In both cases, the new rules created additional complexity by expanding the scope of existing rules that were already complex.

¹²⁹ For instance, the sec. 162(m) $1 million limitation on deductible employee compensation expenses applies to "publicly held corporations" and "covered employees" by reference to the Securities Exchange Act of 1934.

¹³⁰ Treas. Reg. sec. 1.1275-4(b).

¹³¹ See Garlock, Federal Income Taxation of Debt Instruments sec. 9.04[D] (2000).

¹³² Specifically, sec. 1272(a)(6)(B)(iii) requires original issue discount to be computed using a prepayment assumption. This requirement is less likely than the contingent payment debt regulations to provoke securities law concerns because the prepayment assumption is generally based upon more widely available and objective financial information, such as market interest rates.

¹³³ The types of employee retirement benefit plans that can qualify for tax benefits are pension plans, profit sharing plans, stock bonus plans, and annuity plans. The primary tax benefits that qualified retirement plans receive include (1) current deductions for employer contributions to a plan, (2) deferral of taxable income to employees for employer contributions to a plan and earnings of the plan, (3) sec. 72 annuity treatment for distributions from a plan in the form of annuity payments, (4) income deferral for distributions of employer securities until the employee disposes of the securities, (5) income deferral on certain distributions that are rolled over into an IRA, and (6) no imposition of Social Security taxes on distributions and certain employer contributions. In order to qualify for these tax benefits, plans must satisfy numerous conditions, including requirements designed to ensure that funds in the plan are held solely for the benefit of employees and that the plan does not discriminate in favor of owners, management, or other highly compensated employees.

¹³⁴ For example, plans covering sole proprietors (and no employees) are not employee benefit plans subject to ERISA enforcement, but must still satisfy requirements under sec. 401 in order to receive preferential tax treatment.

¹³⁵ Department of Labor Reg. sec. 2530.200a-2 provides that Treasury regulations under secs. 410 and 411 also apply for purposes of ERISA secs. 202 through 204. Conversely, Department of Labor Reg. sec. 2530.200b-2 provides that Department of Labor regulations also apply for purposes of certain overlapping tax sections.

¹³⁶ See sec. 194A(a)(1) (contributions to employer liability trusts), sec. 401 (qualified pension, profit-sharing, and stock bonus plans), sec. 404 (deduction for contributions of an employer to an employees' trust or annuity plan and compensation under a deferred- payment plan), sec. 409 (qualifications for tax credit employee stock ownership plans), sec. 411 (minimum vesting standards), sec. 412 (minimum funding standards), sec. 413(b)(7) (collectively bargained plans, etc.), sec. 414 (employee benefit plan definitions and special rules), sec. 418(b)(7)(B) and (d) (multiemployer plan reorganization status), sec. 418A(a)(2)(A) (notice of multiemployer plan reorganization and funding requirements), sec. 418B(d)(3)(A) (multiemployer plan minimum funding requirement), sec. 418C (overburden credit against multiemployer plan minimum contribution requirement), sec. 418D(a)(1) and (b)(1)(A)(ii) (adjustments in accrued multiemployer plan benefits), sec. 418E (insolvent multiemployer plans), sec. 501 (exemption from tax on corporations, certain trusts, etc.), sec. 3121(a)(5)(F) (Federal Insurance Contributions Act definitions), sec. 3306(b)(5)(F) (Federal Unemployment Tax Act definitions), sec. 4971(g) (taxes on failure to meet minimum employee benefit plan funding standards), sec. 4972(c)(6)(A)(i) (tax on nondeductible contributions to qualified employer plans), sec. 4975 (tax on prohibited transactions by employee benefit plans), sec. 4980B(f)(2)(B)(iv) and (g)(3) (tax on failure of employee benefit plan to satisfy continuation coverage requirements of group health plans), sec. 4980D(f)(2)(B) (tax on failure of employee benefit plan to meet certain group health plan requirements), sec. 6057(a)(1) (annual registration of employee benefit plans), sec. 6058(f) (information required in connection with certain plans of deferred compensation), sec. 6059(d) (periodic report of employee benefit plan actuary), sec. 6103(1)(2) (confidentiality and disclosure of returns and return information), sec. 651 11(d)(6) (limitations on credit or refund), sec. 7476(d) (declaratory judgments relating to qualification of certain retirement plans), sec. 7701(a)(35) (definition of enrolled actuary), sec. 9702(a)(3)(B) (establishment of the United Mine Workers of America Combined Benefit Fund), sec. 9712(a)(2)(B) (establishment and coverage of 1992 United Mine Workers of America benefit plan), sec. 9721 (civil enforcement of coal industry health benefits), sec. 9803(b) (guaranteed renewability in multiemployer group health plans and certain multiple employer welfare arrangements), and sec. 9832(d)(1)(B) (group health plan definitions).

¹³⁷ Pursuant to a reorganization in 1978, the IRS has primary responsibility for participation, vesting, and funding issues, while the Department of Labor has primary responsibility for reporting, disclosure, and fiduciary requirements. However, the Department of Labor may intervene in any matters that materially affect the rights of retirement plan participants, regardless of primary responsibility.

¹³⁸ In 1996, Congress determined that the complexity in administering and applying the tax rules concerning qualified retirement plans was discouraging employers -- particularly small employers -- from establishing any plans at all. Consequently, the Small Business Job Protection Act of 1996 was enacted with a package of pension simplification provisions that included the creation of SIMPLE retirement plans for small businesses.

¹³⁹ Treas. Reg. sec. 1.446-1(a)(1). See Gertzman, Federal Tax Accounting para. 4.02[3] (2000). For instance, sec. 263A requires the capitalization of direct and indirect costs allocable to inventory property. Because generally accepted accounting principles provide a different methodology for determining the capitalization of costs associated with inventory property, there is a divergence of tax treatment from financial accounting treatment with regard to such costs. Other examples of differences between tax accounting and financial accounting include the treatment of bad debts, depreciation of capital assets, deductibility of penalties, income from advance payments, and the deductibility of most reserves (such as warranty costs). By contrast, some tax rules explicitly permit or require conformity to financial accounting, such as: sec. 471(a) (conformity requirement for the last in, first out method of accounting for inventories); Treas. Reg. sec. 1.166-2(d)(3) (permitting banks to elect conformity of bad debt deductions with financial accounting charge-offs required by regulators); Treas. Reg. sec. 1.451-4(d) (conformity requirement relating to accounting for redemption of trading stamps and coupons); Treas. Reg. sec. 1.451-4(b)(1) (modified conformity requirement for income deferral of certain advance payments for provision of goods); and Rev. Proc. 71-21, 1971-2 C.B. 549, sec. 3.11 (modified conformity requirement for income deferral of certain advance payments for provision of services).

¹⁴⁰ In Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979), the Supreme Court stated that "financial accounting has as its foundation the principle of conservatism" and the attendant understatement of income and assets, while "[t]he primary goal of the income tax system, by contrast, is the equitable collection of revenue." In light of these "markedly different goals and responsibilities" the Court concluded that "any presumptive equivalency between tax and financial accounting would be unacceptable." Id. at 542-543. See also PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822, 832 (3d Cir. 2000) (noting that the financial accounting standards in question have "little, if any, bearing on the appropriate tax analysis"); Fidelity Associates, Inc. v. Commissioner, 63 T.C.M. 2327, 2332 (1992) (stating that "it is well recognized that tax accounting requirements may diverge from financial accounting standards and that financial accounting standards are not controlling for tax purposes").

¹⁴¹ There are several other types of differences between the tax rules and financial accounting rules beyond timing differences in the recognition of income and expense. For instance, certain transfers of property may trigger gain or loss recognition under the tax rules but not the financial accounting rules (and vice versa).

¹⁴² Similar complexities arise with regard to the U.S. activities of foreign persons, who must contend with the interaction between U.S. tax laws and the tax laws in their home country.

¹⁴³ The degree of complexity is closely associated with the financial circumstances of the taxpayer, as well as the particular foreign country involved. In fact, individual taxpayers living abroad actually may encounter less complexity from the U.S. tax rules than similarly situated taxpayers residing in the United States because of the sec. 911 gross income exclusion for foreign earned income (up to a specified threshold amount).

¹⁴⁴ There are at least 123 direct references to foreign countries in the Federal tax rules, of which approximately 40 require domestic taxpayers to apply foreign laws or international agreements concerning foreign social security systems in order to determine their Federal tax liability. See sec. 27 (taxes of foreign countries and possessions of the United States; possession tax credit), sec. 56(g)(4)(C)(iii) (adjustments in computing alternative minimum taxable income), sec. 66(d)(3) (treatment of community income), sec. 163(j) (limitation of deduction for interest-stripping), sec. 168(g)(6)(A) (accelerated cost recovery system), sec. 273 (limitation on deduction for life or terminable interest), sec. 275(a)(4) (limitation on deduction for certain taxes), sec. 404A (deduction for certain foreign deferred compensation plans), sec. 461(f) (deductibility of contested liabilities), sec. 515 (credit for taxes of foreign countries and possessions of the United States on unrelated business taxable income), sec. 535(b)(1) (accumulated taxable income subject to accumulated earnings tax), sec. 545(b)(1) (undistributed personal holding company income), sec. 552 (definition of foreign personal holding company), sec. 556(b)(1) (undistributed foreign personal holding company income), sec. 642(a) (foreign tax credits for trusts and estates), sec. 665(d)(2) (definition of taxes imposed on a trust), sec. 702(a)(6) (income and credits of a partner), sec. 703(a)(2)(B) and (b)(3) (partnership computations), sec. 772(d)(6) (simplified flow-through method for electing large partnerships), sec. 807(e)(4)(A) (rules for certain insurance company reserves), sec. 814(f)(1) (contiguous country branches of domestic life insurance companies), sec. 841 (credit for foreign taxes), sec. 842 (foreign companies carrying on insurance business), sec. 853 (foreign tax credit allowed to regulated investment company shareholders), sec. 861(e)(3) (income from sources within the United States), sec. 864(d)(7)(A) (income sourcing definitions and special rules), sec. 865(g)(2) (special source rules for personal property sales by U.S. citizens and residents), sec. 872(b) (exclusions from gross income of nonresident foreign individuals), sec. 877(b) (expatriation to avoid tax), sec. 879(c)(2) (tax treatment of certain community income of nonresident foreign individuals), sec. 883(a) (exclusions from foreign corporation gross income), sec. 891 (doubling of rates of tax on citizens and corporations of certain foreign countries), sec. 893 (compensation of employees of foreign governments or international organizations), sec. 894(c) (income affected by treaty), sec. 896 (adjustment of tax on nationals, residents, and corporations of certain foreign countries), sec. 901 (credit for taxes of foreign countries and of possessions of the United States), sec. 902 (deemed paid foreign tax credit where domestic corporation owns 10 percent or more of voting stock of foreign corporation), sec. 903 (foreign tax credit for taxes in lieu of income, etc., taxes), sec. 904(c) and (d) (limitation on foreign tax credit), sec. 907(b) (special foreign tax credit rules in case of foreign oil and gas income), sec. 911(d)(8)(A) (gross income exclusion for citizens or residents of the United States living abroad), sec. 954(b)(4) (subpart F foreign base company income), sec. 964(b) (miscellaneous subpart F provisions), sec. 999 (international boycotts), sec. 1014(b) (basis of property acquired from a decedent), sec. 1293(g)(1)(B)(i) (current taxation of income from passive foreign investment company qualified electing funds), sec. 1401(c) (rate of self-employment income tax), sec. 1503(d)(2) (computation and payment of tax by consolidated groups), sec. 1504(d) (certain subsidiaries in contiguous countries treated as includible corporations of consolidate group), sec. 2014 (credit for foreign death taxes), sec. 2108 (application of pre-1967 estate tax provisions), sec. 3101(c) (rate of employee Federal Insurance Contributions Act tax), sec. 3111(c) (rate of employer Federal Insurance Contributions Act tax), sec. 3121(b)(12)(B) (Federal Insurance Contributions Act tax definitions), sec. 3306(c)(12)(B) (Federal Unemployment Tax Act tax definitions), sec. 3401(a)(8)(A) (wage withholding definitions), and sec. 4221(e)(1) (certain manufacturers excise tax-free sales).

¹⁴⁵ Treas. Reg. sec. 1.901-2(a)(2)(i).

¹⁴⁶ Id.

¹⁴⁷ Courts have consistently expressed deference to foreign jurisdictions in the interpretation of their own laws, while reserving the right to construe the U.S. tax rules on the basis of the factual consequences arising from the application of foreign laws (as interpreted by the foreign jurisdiction). See, e.g., Biddle v. Commissioner, 302 U.S. 573 (1938).

¹⁴⁸ Riggs Nat'l Corp. v. Commissioner, 163 F.3d 1363 (D.C. Cir. 1999), rev'g and remanding 107 T.C. 301 (1996). "Net loans" provide for the borrower to pay a fixed interest rate, net of the lender's liability for local taxes that are withheld and paid by the borrower. Because a net loan provides for a fixed net interest rate, the borrower bears the risk of any increases in the tax rate and benefits from any decreases in the tax rate.

¹⁴⁹ The IRS based its position upon rulings by the Brazilian Supreme Court and Brazilian Revenue Service indicating that the Brazilian Central Bank was immune from taxes on net loan transactions, notwithstanding a later ruling by the Brazilian Finance Minister that the Brazilian Central Bank was required to withhold and pay taxes on net loans.

¹⁵⁰ The appellate court determined that the Brazilian Finance Minister did, in fact, implement its ruling and require the Brazilian Central Bank to withhold and pay Brazilian taxes on the net loans. According to the appellate court, the IRS position and Tax Court decision were based upon an impermissible inquiry into the binding effect of the Brazilian Finance Minister ruling under Brazilian law. On remand, the Tax Court again held that the Brazilian taxes were not eligible for the foreign tax credit because the taxpayer could not establish that the taxes were actually paid by the Brazilian Central Bank. Riggs Nat'l Corp. v. Commissioner, 81 T.C.M. (CCH) 1023 (2001). The requirement that the foreign taxes actually be paid has been another contentious issue involving foreign tax credits, particularly as it relates to loans that have been made to foreign borrowers. Bankers Trust N.Y. Corp. v. United States, 225 F.3d 1368 (Fed. Cir. 2000); Norwest Corp. v. Commissioner, 69 F.3d 1404 (8 Cir. 1995); Continental Ill. Corp. v. Commissioner, 998 F.2d 513 (7 Cir. 1993).

¹⁵¹ See, e.g., United States v. Goodyear Tire & Rubber Co., 493 U.S. 132 (1989); Amoco Corp. v. Commissioner, 138 F.3d 1139 (7th Cir. 1998); Vulcan Materials Co. v. Commissioner, 96 T.C. 410 (1991), aff'd per curiam, 959 F.2d 973 (11 Cir. 1992), nonacq. 1995-1 C.B. 1.; Phillips Petroleum Co. v. Commissioner, 104 T.C. 256 (1995). See also Isenbergh, The Foreign Tax Credit: Royalties, Subsidies, and Creditable Taxes, 39 Tax L. Rev. 227, 228 (1984) ("How much a foreign tax system can differ from ours in its structure and practical effect and still give rise to creditable income taxes has been a matter of dispute virtually since the credit was introduced.").

¹⁵² For instance, double taxation issues could arise to the extent that adjustments required by the sec. 482 arm's-length standard are not recognized by the foreign jurisdiction. See Procter & Gamble Co. v. Commissioner, 95 T.C. 323 (1990), aff'd, 961 F.2d 1255 (6th Cir. 1992); Exxon Corp. v. Commissioner, 66 T.C.M. (CCH) 1707 (1993). These double taxation issues can be resolved through a competent authority process under the mutual agreement procedures of a tax treaty between the United States and the foreign jurisdiction, although resolution of issues under this procedure is not assured and the process can be lengthy. Alternatively, some of the complexities in this area have been somewhat addressed by the use of advance pricing agreements.

¹⁵³ There are several other examples of cross-border tax arbitrage opportunities. See Rosenbloom, The David R. Tillinghast Lecture: International Tax Arbitrage and the "International Tax System", 53 Tax L. Rev. 137 (Winter 2000). For a statutory response to international tax arbitrage in the treaty context, see sec. 894(c), which denies treaty benefits to foreign persons with regard to reduced withholding tax rates on items of income derived through an entity that is treated as a partnership (or is otherwise treated as fiscally transparent) for U.S. tax purposes if (1) such item is not treated for purposes of the treaty partner's tax laws as an item of income of such person, (2) the treaty does not contain a provision addressing the applicability of the treaty in the case of income derived through a partnership or other fiscally transparent entity, and (3) the foreign treaty partner does not impose tax on an actual distribution of such item of income to such person.

¹⁵⁴ There are at least 34 sections of the Code containing direct references to treaties. See sec. 163(e)(3)(A) and (j) (original issue discount; interest-stripping rules), sec. 245(a)(10) (dividends received from certain foreign corporations), sec. 269B(d) (stapled entities), sec. 535(b)(9) (accumulated taxable income subject to accumulated earnings tax), sec. 543(a)(4) (personal holding company income treatment of copyright royalties), sec. 545(b)(7) (undistributed personal holding company income), sec. 643(a)(6)(B) (definitions applicable to estates, trusts and beneficiaries), sec. 814(f)(2) (contiguous country branches of domestic life insurance companies), sec. 865(h)(2)(A)(ii) (source rules for personal property sales), sec. 877(e) (expatriation to avoid tax), sec. 884 (branch profits tax), sec. 892(a)(3) (income of foreign governments and of international organizations), sec. 894 (income affected by treaty), sec. 897(i) (disposition of investment in United States real property), sec. 904(g)(10) (limitation on foreign tax credit), sec. 943(e)(1) (other foreign sourcing definitions and special rules), sec. 952(b) (subpart F income defined), sec. 953(c)(3)(C)(i)(II) and (d)(1)(D) (subpart F insurance income), sec. 1248(d)(4) (gain from certain sales or exchanges of stock in certain foreign corporations), sec. 1293(g)(1)(B)(ii)(III) (current taxation of income from passive foreign investment company qualified electing funds), sec. 1298(b)(8) (special passive foreign investment company rules), sec. 2102(c)(3)(A) (nonresident foreign estate credits against tax), sec. 3405(e)(1)(B)(iii) (special rules for pensions, annuities, and certain other deferred income), sec. 4373(1) (foreign insurer excise tax exemptions), sec. 6049(b)(5)(B)(ii) (returns regarding payments of interest), sec. 6105 (confidentiality of information arising under treaty obligations), sec. 6110(i)(1)(B) (public inspection of written determinations), sec. 6114 (treaty-based return positions), sec. 6511(d)(3) (limitations on credit or refund), sec. 6712 (failure to disclose treaty-based return positions), sec. 6724(d) (information reporting requirement waivers, definitions, and special rules), sec. 7422(f)(1) (civil actions for refund), sec. 7803(b)(2)(C) (Commissioner of Internal Revenue; other officials), and sec. 7852(d) (conflicts between U.S. tax laws and tax treaties).

¹⁵⁵ Conversely, coordination between U.S. tax laws and tax treaties may be carried out in provisions of the treaties themselves. For instance, tax treaties often provide rules that specify the residence or domicile of an individual who may be subject to tax as a resident under the domestic laws of both treaty partners. The United States typically includes in its tax treaties a "saving clause" in order to preserve its right to tax U.S. citizens or residents who are residents of treaty partners. Unless otherwise provided in the treaty, the saving clause generally allows the United States to continue to tax its citizens or residents as if the treaty was not in force. However, the scope of saving clauses differs among various treaties. Some saving clause provisions apply only to preserve U.S. taxing jurisdiction over its current citizens or residents, while other saving clause provisions are broader in scope and apply to both current and former U.S. citizens (but not former long-term U.S. residents). Still other saving clause provisions apply to both former U.S. citizens and former long-term U.S. residents.

¹⁵⁶ For example, compare sec. 643(a)(6)(B) (U.S.-source gross income of foreign trust determined without regard to treaty provisions) with sec. 865(h)(2)(A)(ii) (general sourcing rule for gain from sale of certain stock or intangibles subject to treaty provisions).

¹⁵⁷ See, e.g., Whitney v. Robertson, 124 U.S. 190, 195 (1888); Reid v. Covert, 354 U.S. 1, 18 (1957). In order to prevent a wholesale application of the "later-in-time" rule when the Internal Revenue Code was recodified and reenacted in 1954, Congress provided a saving clause in sec. 7852(d)(2) stating that treaty rules in effect on August 16, 1954, had priority over the recodified tax laws (other than subsequently enacted laws). Although Congress did not update the sec. 7852(d)(2) saving clause when it recodified the Internal Revenue Code in 1986, sec. 7852(d)(2) has nevertheless been interpreted to apply to the 1986 recodification.

¹⁵⁸ See Technical and Miscellaneous Revenue Act of 1988, Pub. Law No. 100-647, sec. 1012(aa)(1)(A).

¹⁵⁹ In discussing the complex interaction between U.S. tax laws and tax treaties, the Senate Finance Committee report explained at length the challenges involved in providing a prospective tax rule that resolves future conflicts:

The committee believes that a basic problem that gives rise to

¹⁶¹ Not all complexity results in taxpayer confusion or uncertainty. Sometimes the tax law is clear but involves a large number of steps or calculations. This kind of complexity would not result in greater taxpayer confusion (or uncertainty), but it could be intimidating. When faced with complicated and lengthy calculations, individual taxpayers preparing their own tax returns may choose to skip the calculations and forgo tax benefits intended for them. For example, the General Accounting Office reports that in tax year 1998, approximately 510,000 individual taxpayers did not itemize their deductions even though it appeared that it would have reduced the amount of income taxes that they owed. General Accounting Office, Estimates of Taxpayers Who May Have Overpaid Federal Taxes by Not Itemizing (GAO/GGD-01-529), April 12, 2001.

¹⁶² McCaffery, The Holy Grail of Tax Simplification, 1990 Wis. L. Rev. 1267, 1291 (Sept. /Oct. 1990) ("Complexity is also expensive. Money is spent on developing studies, rules and forms. Highly skilled individuals are needed as interpreters and tax advice itself is deductible, depriving the government of revenue. Given a fixed revenue-raising system, the dollar costs of complexity are spread over all taxpayers. A particular irony is that all must pay for complexities that, instead of serving equity, may benefit only a few.").

¹⁶³ These estimates reflect the complexity of the Federal tax law as indicated by the number of forms, and line items on those forms, that taxpayers file. When these forms, or the line items increase, the estimates of the amount of time that taxpayers spend on return preparation activities generally increases.

¹⁶⁴ See the 2000 Form 1040 Instruction Booklet, page 56.

¹⁶⁵ Section 2001 of the IRS Reform Act states that it is the goal of the IRS that 80 percent of all returns be filed electronically by 2007 (Pub. Law No. 105-206, July 22, 1998).

¹⁶⁶ Slemrod & Sorum, The Compliance Cost of the U.S. Individual Income Tax System, 37 Nat'l Tax J. 461 (1984).

¹⁶⁷ The IRS no longer includes these estimates in its budget documents.

¹⁶⁸ The Tax Foundation's estimate of $39.60 per hour is similar to the estimates contained in Costly Returns: The Burdens of the U.S. Tax System, by James L. Payne, Institute for Contemporary Studies, San Francisco, 1993. Because many individuals who use return preparers do not use preparers at the large national accounting firms, it is not clear that a national accounting firm's hourly rate is appropriate for use in this context.

¹⁶⁹ The estimate may be upward biased because individuals whose value of time is greater than the cost of using a tax professional will generally use tax professionals, while individuals whose value of time is less than that of the tax professional will generally find it too expensive to use their services, and prepare the returns themselves. The approach used by the Tax Foundation would be appropriate for those taxpayers who use tax professionals with costs that equal or exceed $39.60 per hour, but would be inappropriate for the more than one-half of individual tax returns that 1) did not use a tax professional or 2) used a tax professional that was less costly than $39.60 per hour.

¹⁷⁰ Other ways in which taxpayers can obtain assistance from the IRS in complying with the tax laws include walk-in sites where taxpayers can get answers to questions, IRS-sponsored volunteer organizations that provide assistance to eligible taxpayers, and various outlets through which taxpayers can receive tax forms and publications.

¹⁷¹ General Accounting Office, Tax Administration: Assessment of IRS' 2000 Filing Season (GAO-01-158), Dec. 22, 2000, 10-14.

¹⁷² Id. at 20-21. Between March and June 2000, the Treasury Inspector General for Tax Administration conducted a test in which it electronically submitted 50 questions to ETLA relating to tax law issues encountered by small business and self-employed taxpayers, and found that the IRS correctly responded to 54 percent of the questions. Treasury Inspector General for Tax Administration, Management Advisory Report: Comparison of Responses to Small Business/Self-Employed Taxpayer Questions from the Electronic Tax Law Assistance Program and Other Internet Tax Law Services (2000-30- 126), Sept. 21, 2000. The report states that the results are not statistically valid because of the limited number of submitted questions, but that "we believe our sample of 50 questions is sufficient to provide insight into the service the IRS provided to Small Business/Self-Employed Taxpayers." The report states that the questions also were submitted to three commercial Internet sites that offer free tax advice. These sites provided correct answers 47 percent of the time.

¹⁷³ The summaries provided by the Law Library of the Library of Congress are attached as part of Appendix D to this study and are dated August and September 2000. For another perspective on approaches to simplification both as a matter of style and substantive reform, the Harvard University International Tax Program sponsored a project of drafting a tax code for developing countries. The Basic World Tax Code and Commentary adopted a drafting style that "emphasizes clarity of organization, consistency and precision of expression, and economy of words" and was intended in part as a guide to developing countries in their efforts to improve efficiency and fairness in revenue raising. See Hussey & Lubick, Basic World Tax Code and Commentary (Tax Analysts 1996).

¹⁷⁴ During the Joint Committee study, Ms. Olson was named the National Taxpayer Advocate.